Chapter 17, Problem 6PS

MM’s propositions What is wrong with the following arguments?

1. a. As the firm borrows more and debt becomes risky, both stock- and bondholders demand higher rates of return. Thus, by reducing the debt ratio, we can reduce both the cost of debt and the cost of equity, making everybody better off.
2. b. Moderate borrowing doesn’t significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won’t increase the expected rate of return demanded by stockholders.
3. c. A capital investment opportunity offering a 10% internal rate of return is an attractive project if it can be 100% debt-financed at an 8% interest rate.
4. d. The more debt the firm issues, the higher the interest rate it must pay. That is one important reason that firms should operate at conservative debt levels.