Final answer:
The incremental cost of borrowing dictates whether new debt will generate returns exceeding its cost, influencing a firm's decision to increase debt for positive leverage. Factors such as a firm's profit history, economic interest rates, and credit history affect the attractiveness of a loan.
Step-by-step explanation:
When deciding if increasing the debt amount would contribute to positive leverage, the incremental cost of borrowing indicates to a borrower whether the additional funds obtained through debt will generate returns greater than the cost of the new debt. Essentially, if the cost of borrowing is lower than the expected return on the investment made with the borrowed funds, it could lead to positive leverage, improving the company's profitability. It is important to consider factors such as prevailing interest rates, the borrower's credit history, and the economic environment to assess the attractiveness of a loan.
For instance, if the borrower is a firm with a record of high profits, the loan is seen as less risky, and the firm can typically secure a lower borrowing cost. Likewise, if general interest rates in the economy have fallen, existing loans become more valuable, and new loans may be cheaper, thereby possibly justifying an increased level of debt for the firm. Conversely, if interest rates have risen, or if the borrower has a history of late payments, the incremental cost of borrowing would be higher, potentially making it less likely that new debt would contribute to positive leverage.