Assume that the risk-free interest rate in the U.S. is the same as that in Country M. Assume that the government of Country M is more likely to rescue local firms that experience financial problems. Other things being equal, Country M's firms are likely to use a ____ degree of financial leverage than U.S. firms. If a firm based in Country M had the same degree of financial leverage and the same operating characteristics as a U.S. firm, its cost of capital would be ____ than that of the U.S. firm.
A) higher; higher
B) higher; lower
C) lower; lower
D) lower; higher

Question

Quizplus · Accepted Answer

Country M's firms are likely to use a higher degree of financial leverage because the government is more likely to rescue them in financial distress, reducing the perceived risk of high leverage. If a firm in Country M has the same leverage and operating characteristics as a U.S. firm, its cost of capital would be lower due to the implicit government support reducing risk.

Assume That the Risk-Free Interest Rate in the U