If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Question

Quizplus · Accepted Answer

An increase in the slope of the SML would result in a higher required rate of return on equity, rs. Since equity is riskier than debt, the impact would be greater on rs than on rd for most firms. This would lead to an increase in the use of debt and a decrease in the use of equity, as debt becomes relatively cheaper (compared to equity). However, an excessive use of debt would increase the overall riskiness of the firm, which may limit the shift toward debt.

If Investors' Aversion to Risk Rose, Causing the Slope of the SML