M&M's Proposition II suggests that in a world of no taxes and no bankruptcy,________. A)no matter what the debt-equity ratio is,the R_a or WACC of the firm increases with debt B)the value of the firm is sensitive to the funding choice between debt and equity C)in simple terms,as the firm adds more debt to the financing mix,the shareholders require a higher and higher return on equity such that it exactly offsets the use of the cheaper debt D)Statements A,B,and C are all incorrect.

Question

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M&M Proposition II states that in a world of no taxes and no bankruptcy, the value of the firm is independent of its capital structure. However, the cost of equity increases with the amount of debt used to finance the firm, so that the weighted average cost of capital (WACC) remains constant. This is the famous "leverage irrelevance" principle. As debt increases, the cost of debt remains constant, while the cost of equity increases in proportion to the amount of debt because of the increased risk to equity investors. As a result, the overall WACC remains constant, but the required return on equity (R_a) increases to offset the use of leverage. This means that the shareholders require a higher return on equity to compensate for the added risk of bankruptcy, which exactly offsets the tax benefit of using cheaper debt.

M&M's Proposition II Suggests That in a World of No