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It says the statement 1 of this quesiton is not right and according to the standard answer, it says “in the traditional view, there is a curvilinear relationship between the cost of equity and financial risk.”
However, according to our lectures and free notes, in the diagram, there is a curvilinear relationship between the WACC (instead of cost of equity) and financial risk, and line of the cost of equity (which is above the WACC line) actually shows a linear relationship with gearing (thus the statement 1 should be right).
Could you please explain this for me? Thank you so much sir!!
Although we tend to show the cost of equity as though it is linear, it does not have to be linear – iii could be anything. All that matters is that the cost of equity increases with higher gearing.
(According to Modigliani and Miller it will in theory be linear, but that does not matter for the traditional view.)
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