Question

Under proposition II, the required rate of return on the firm is a linear straight line with an upward slope because:
Select one:
a. The weighted average cost of capital (WACC) is downward sloping
b. As a firm increases its debt/equity ratio the risk of bankruptcy is higher
c. As a firm increases its debt/equity ratio the net cashflow increases.
d. The weighted average cost of capital remains the same no matter the debt/equity ratio

Answer 1

The correct answer is

d) The weighted average cost of capital remains the same no matter the debt/ equity ratio

Here according to the MM proposition II, as the debt in the capital structure increases the cost of equity will rise so adding debt would not have the effect of reducing the WACC and the WACC will not change.

The WACC will not be downward sloping and with the rise in debt/equity ratio the cost of equity does rise. With rise in debt the cash flow might increase or might not increase.