International Financial Management: An Analytical Framework, 2nd Edition by Pearson

364 INTERNATIONAL FINANCIAL MANAGEMENT

overall cost of capital of the firm. For example, if the firm decides to use more debt (because

debt capital is cheaper than equity capital) and less equity capital, the proportions of debt

and equity capital of the firm will change. This will tend to lower the overall cost of capital of

the firm. But the increase in the use of debt beyond some threshold will increase the risk of

both the debt and the equity, leading to an increase in component costs and thus, the overall

cost of capital. In other words, the disadvantage with the increase in proportion of debt will

tend to more than offset the advantage (interest tax shield) of the debt. Thus, the firm has to

make a tradeoff between the advantage of de ...