For the question: draw the graph of cost of capital as you move from 100% equity to 100% debt, I have heard that the answer is that it looks like a smiley face.
However, I thought that cost of debt is always lower than cost of equity. Can anyone explain?
Thank you
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Debt is always cheaper than equity, however, two things are important here. 1 - your cost of debt goes up as you add more debt, driven by investors needing to be compensated for default risk on debt 2 - your cost of equity goes up with leverage (you have to unlever/relever beta at each new leverage)
Eventually, the tax benefits are outstripped by your increasing costs of debt/equity. Damodaran has a spreadsheet that uses iteration to calculate optimal D/E given a set of inputs on his site.
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