When debt is risky under MM II:
A) bondholders shift more of the risk to equityholders.
B) equityholders shift more of the risk to bondholders.
C) the value of the interest tax shield is at its highest.
D) there is more overall risk in the firm.

Question

Quizplus · Accepted Answer

According to Modigliani and Miller's Proposition II, in a world with no taxes or bankruptcy costs, debt is irrelevant in determining the value of a firm. However, when debt becomes risky, it increases the likelihood of bankruptcy which leads to higher default costs. Equityholders are inherently holders of a residual claim and thus have a higher tolerance for risk. In order to mitigate risk, equityholders may shift more of the risk to bondholders by taking on safer projects or reducing dividend payouts. Therefore, option B is the correct answer.

When Debt Is Risky Under MM II