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 through C are all incorrect.

Question

Quizplus · Accepted Answer

M&M's Proposition II suggests that the value of the firm is independent of its capital structure in a world of no taxes and no bankruptcy. However, the cost of equity increases with increasing debt, thereby offsetting the advantage of cheaper debt. Therefore, choice C is correct as it summarizes the key message of M&M's Proposition II. Choices A and B are incorrect as they suggest that the value of the firm and its cost of capital are affected by the debt-equity ratio, which is not the case in the absence of taxes and bankruptcy. Choice D is incorrect as choice C is correct.

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