Which of the following statements are correct in relation to M & M Proposition II with no taxes?
I.The required return on assets is equal to the weighted average cost of capital.
II.Financial risk is determined by the debt-equity ratio.
III.Financial risk determines the return on assets.
IV.The cost of equity declines when the amount of leverage used by a firm rises.
A)I and III only
B)II and IV only
C)I and II only
D)III and IV only
E)I and IV only

Question

Quizplus · Accepted Answer

M&M Proposition II with no taxes states that the cost of capital of a levered firm is equal to the cost of capital of an unlevered firm plus a premium for financial risk. Therefore, statement I is correct. Statement II is also correct because the debt-equity ratio determines the financial risk, which affects the cost of capital. Statement III is incorrect because financial risk affects the cost of capital, not the return on assets. Statement IV is incorrect because the cost of equity increases when leverage is added, not decreases.

Which of the Following Statements Are Correct in Relation to M