What is the implication of a higher cost of debt in a company's valuation?

A higher cost of debt typically indicates that a company faces greater financial risk. When the cost of debt increases, it suggests that lenders perceive the company as having a higher likelihood of defaulting on its obligations. This increased default risk directly impacts the company's valuation negatively, as investors will demand a higher return to compensate for the increased risk associated with lending to the company.

As a result, the net present value of future cash flows becomes less attractive, leading to a decrease in the company's implied valuation. Investors and analysts often use measures like the weighted average cost of capital (WACC), which includes the cost of debt, in their valuation models. A higher cost of debt raises the WACC, resulting in a lower valuation when projecting future earnings and cash flows. Thus, the correct answer highlights how an elevated cost of debt diminishes the company’s valuation due to the heightened risk of default perceived by investors.