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Which of the following statement concerning capital structure theory is correct?
A. In the traditional view, there is a linear relationship between the cost of equity and financial risk
B. Modigliani and Miller said that, in absence of tax, the cost of equity would remain constant.
C. Pecking order theory indicates that preference shares are preferred to convertible debt as a source of finance.
There’s a debate between A and B.
There is no debate!! 🙂
M&M do not say that the cost of equity will remain constant at all – they say (in the absence of tax) that the WACC will remain constant.
The traditional view is that the cost of equity will rise with greater financial risk, but not necessarily linearly. (It is M&M who proved it rises linearly (subject to how gearing is measured)).
The correct answer is C
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