M&M Proposition II with tax supports the argument that a ﬁrm's:
A) Cost of equity decreases as its weighted average cost of capital decreases.
B) Cost of equity increases as the ﬁrm increases its debt-equity ratio.
C) Cost of debt varies inversely with the debt-equity ratio.
D) Use of debt decreases the value of the ﬁrm.
E) Weighted average cost of the capital remains constant as the debt-equity ratio rises.

Question

Quizplus · Accepted Answer

According to M&M Prop II with tax, the cost of equity increases as the firm increases its debt-equity ratio. This is because as the firm increases its use of debt, the risk to equity holders also increases, thus requiring a higher return to compensate for the added risk.

M&M Proposition II with Tax Supports the Argument That a ﬁRm's