4. Suppose a new company decides to raise a total of $200 million, with $100 mil

Question

4.
Suppose a new company decides to raise a total of $200 million, with $100 million as common equity and $100 million as long-term debt. The debt can be mortgage bonds or debentures, but by an iron-clad provision in its charter, the company can never raise any additional debt beyond the original $100 million. Given these conditions, which of the following statements is CORRECT?
a. The higher the percentage of debt represented by mortgage bonds, the riskier both types of bonds will be and, consequently, the higher the firm

Explanation / Answer

Statement C is correct. As company can't decrease its total debt of $100 million by the mix of debentures and mortgage bonds, if this way exists at all, we can observe the situation of the increase in debentures' risk when mortgage debt rises. Also the issue of mortgage bonds causes the growth of mortgage bonds' risk. Thus the Weighted Average Cost of Debt will probably stay constant enough

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