14 4.

Explain what is wrong with the following argument: "If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm's equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity."

(Select the best choice below.)

A.

The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it the least because it does not share any of the risk.

B.

The argument is correct.

C.

The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it the most because it does not share any of the risk.

D.

The argument is correct because debt has a lower cost of capital than equity and a firm can reduce its overall weighted average cost of capital by increasing the amount of debt financing.