The contribution of M&M comes from the fact that there is a constant tradeoff ra

Question

The contribution of M&M comes from the fact that there is a constant tradeoff ratio. Which of the statements below describe this constant tradeoff ratio?

A.

When a firm adds more low cost debt, it automatically increases the cost of equity so that the overall cost of capital decreases.

B.

When a firm adds more low cost debt, it automatically increases the cost of equity so that the overall cost of capital increases.

C.

When a firm adds more low cost debt, it automatically increases the cost of equity so that the overall cost of capital remains constant.

D.

None of these

Explanation / Answer

The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.

When company add more low cost debt the levered beta increases and so cost of equity is also increases. But due to tax benefit on the debt the overall cost of capital decreases.

Hence, option (A) is correct answer,

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