GK
ACCOUNTING
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Question
[CLICK ON ANY CHOICE TO KNOW THE RIGHT ANSWER]
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R = Equity /100
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R = Equity / Income
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R = (Equity / Debt) x 100
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None of these
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Detailed explanation-1: -The second proposition of the M&M Theorem states that the company’s cost of equity is directly proportional to the company’s leverage level. An increase in leverage level induces a higher default probability to a company.
Detailed explanation-2: -Thus, with an increase in financial leverage, the cost of equity increases. WACC (Weightage Average Cost of Capital) remains constant; and with the increase in debt, the cost of equity increases. An increase in debt in the capital structure results in increased risk for shareholders.
Detailed explanation-3: -Miller and Modigliani theory mentions two propositions. Proposition I states that the market value of any firm is independent of the amount of debt or equity in capital structure. Proposition II states that the cost of equity is directly related and incremental to the percentage of debt in capital structure.
Detailed explanation-4: -According to MM proposition 2 (without taxes) the overall cost of capital (WACC) depends upon the firm’s business risk and will remain constant irrespective of the firm’s capital structure.