Question

Establish whether the following statements are TRUE, FALSE, or AMBIGUOUS and provide a justification for your answer.

In a perfect capital market, shareholders prefer not to use debt because equity becomes riskier as the debt-to-equity ratio increases?

Answer 1

TRUE

In a perfect capital market, shareholders prefer not to use debt because equity becomes riskier as the debt-to-equity ratio increaseS. As the proportion of the debt increases in the capital structure the financial risk increases which in turn increases the risk of bankruptcu of the company and hence increase the requried return on the equity. As debt payments have a priority over the return to equity hence the cost of debt is lower than equity. but there has to be a appropriate mix of debt and equity in the capital structure.