bhavikachandru8

Financial Risks occurs when the firm decides to use debt in its capital structure. if that is true, then answer the following question below. if, indeed, debt increases the cost of equity, which variable in the following formula that (debt risk) be implied and how is it capture? r_s = r_rf + (r_m - r_rf)beta

How would you answer in the following debate?

Question:

Isn't it true that the riskiness of a firm's equity will rise if the firm increases its use of debt financing?

Answer:

Yes, that's the essence of the MM proposition 2.

Question:

And isn't it true that, as a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the risk of the firm's debt?

Answer:

Yes.

Question:

In other words, increased borrowing increases the risk of the equity and the debt?

Answer:

Thats right.

Question:

well, given that the firm uses only debt and equity financing, and given that the risks of both are increased by increased borrowing, does it not follow that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm?

Answer:?

True or False: MM's proposition II assumes increased borrowing does not affect the interest rate on the firm's debt.

Which one of the following statements is correct?

Protective covenants prevent bond issuers from irresponsible overborrowing behavior and are offered for the benefit of:
A. common shareholders.
B. preferred shareholders.
C. bondholders.
D. both common and preferred shareholders.