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I came across a point on limitation of Mm theory in gearing.
The limitation is that with “gearing level increase, there is an apparent paradox that cost of equity fall and cost of debt increases which is contradicting with the assumptions of MM” further explaination is that, risk adverse shareholders sell shares to investors who are risk taker, thus this will affect the cost of equity to fall”
My question is why cost of equity fall? I could not understand the relationship behind this.
I don’t know where you read this, but I am not sure that it is correct.
M&M assume that people will accept more risk provided that they get a higher return. So more gearing means more risk means higher cost of equity.
What the statement is trying to say is that there could be some investors who in fact want more risk and therefore do not want a higher return. This is obviously possible (but not so likely). If that was the case then it could be that the cost of equity actually fell. However again rather unlikely!!
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