The contribution of M&M comes from the fact that there is a constant trade-off ratio.Which of the statements below describe this constant trade-off ratio?
A)When a firm adds more low cost debt,it automatically increases the cost of equity so that the overall cost of capital remains constant.
B)When a firm adds more low cost debt,it automatically increases the cost of equity so that the overall cost of capital increases.
C)When a firm adds more low cost debt,it automatically increases the cost of equity so that the overall cost of capital decreases.
D)None of these

Question

Quizplus · Accepted Answer

According to the M&M theory, the cost of capital of a firm remains constant and is independent of the capital structure. Thus, when a firm adds more low cost debt to its capital structure, the cost of equity increases proportionately to maintain the overall cost of capital constant. This trade-off ratio is constant and the main contribution of M&M. Therefore, statement A is the correct option.

The Contribution of M&M Comes from the Fact That There