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Assume capital markets are perfect without frictions. Assume all people are risk averse. Which of the...

Assume capital markets are perfect without frictions. Assume all people are risk averse. Which of the following is true?

  • A. Higher leverage is good for the equity holders up until a point. If leverage is too high, it starts being bad for shareholders.
  • B. Risk of equity increases even if the company has very low leverage ratio and increases leverage by just a little.
  • C. Higher leverage will not change the return on equity.
  • D. Higher leverage makes shareholders better off because they can enjoy a higher rate of return.
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Answer #1

Answer - Option B (Risk of equity increases even if the company has very low leverage ratio and increases leverage by just a little)

Reason - Since all people are risk averse which means that Risk taking ability & Willingness is low. Hence People will not support Higher Leverage & Risk can increase even with the slightest of the Leverage increase.

All other options are because all other options suggest Higher Leverage which Risk Averse people will avoid Assuming capital markets are perfect without frictions.

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