Question: Figure shows that r D increases as the debt?equity ratio increases. In MM?s world r E also increases but at a declining rate. Explain why.

Figure shows that r_D increases as the debt?equity ratio increases. In MM?s world r_E also increases but at a declining rate. Explain why.

Redraw Figure, showing how r_D and change for increasingly high debt?equity ratios. Can r_D ever be higher than? Can r_E decline beyond a certain debt?equity ratio?

Rates of return -rE (MM) TE (traditional) -rA (MM) TA (traditional) debt

Rates of return -rE (MM) TE (traditional) -rA (MM) TA (traditional) debt equity Traditionalists believe there is an optimal debt-equity ratio that minimizes rA alw

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