investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity.However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Question

Quizplus · Accepted Answer

The statement is true because the investors' aversion to risk increases the slope of the security market line (SML). As a result, the required rate of return on equity (rs) increases more than the interest rate on long-term debt (rd). This leads to an increase in the use of debt and a decrease in the use of equity. However, if firms use a lot more debt, it could increase the riskiness of both debt and equity, which can limit the shift toward debt.

Investors' Aversion to Risk Rose, Causing the Slope of the SML