Question

MM Proposition II states that:

I) the expected return on equity is positively related to leverage;
II) the required return on equity is a linear function of the firm's debt to equity ratio;
III) the risk to equity increases with leverage

Select one:

a. I only

b. III only

c. II only

d. I, II, and III

which one is correct?

Answer 1

where RL is required return on equity (or cost of levered equity)

RU is unlevered cost of equity

D is the amount of debt financing

E is the amount of equity financing

RD is the cost of debt

Leverage is simply defined as portion of debt in total financing, i.e., D/(D+E)

Statement 1 and 2 are true which can be seen from the equation

Statement 3 is true because an increase in leverage level causes increased default chances of a company. As a result, investors tend to demand a higher (return) to be compensated for the additional risk.

Hence, option (d) is correct