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Why are the following statements below, false?
Question 1
Statement 1: In the traditional view, there is a linear relationship between the cost of equity and financial risk.
Isn’t this statement true? Because as the financial risk increases, the Ke increases too right ?
Question 2
According to both the traditional view and the Modigliani and Miller (II) view of capital structure :
Statement 1 : The WACC is minimized at the maximum level of gearing.
Why is this statement wrong ? The WACC is the lowest at the optimal point where the debt = 100% right?
1. Higher financial risk does certainly mean higher shareholders required return, but there is no reason for it to be a linear relationship.
2. It may be true for M&M with tax, but not true for the traditional view (watch my lectures because I do explain this).
Oh. For question 2 , I think i misinterpreted the question again. I thought the statements either can be true for M&M with tax or the traditional view. I didnt know that it’s suppose to be true for both the traditional and M&M with tax. Now, i get it. Thank you sir.
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