Question

b) MM's proposition 2 says that the cost of equity increases with borrowing and that

   the increase is proportional to D/V, the ratio of debt to firm value.

c) MM's proposition 2 assumes that increased borrowing does not affect the interest

    rate on the firm's debt.

d) Borrowing does not increase financial risk and the cost of equity if there is no risk

    of bankruptcy.

True or False. Explain

Answer 1

B) False

Explanation: The increase in cost of equity with borrowing is not proportional to increase in debt / value ratio. The cost of equity increases at a higher rate than debt/value ratio. The higher the increase in borrowing , the higher would be the cost of equity.

C) False

Explanation: Increased in borrowing increases the risk of bankruptcy and hence increases the cost of debt with every borrowing.

D) False

Explanation: Even if there is no banruptcy, the cost of equity increases because the company will have most of its assets as collateral and a very high amount of interest to be paid on the debt, which would increase the risk for equity, leading it to increase in cost of equity.