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Which of the following statements 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 Miller said that, in the 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
d) Business risk is assumed to be constant as the capital structure changesFirst of all, I am confused about what does the linear relation means? Secondly, I am confused with the answer (d) because I am not aware of the changes in capital structure caused by business risk & financial risk!
Please explain to me SIR what changes in capital structure is caused by business risk & financial risk!
A linear relation exists if the graph of the changes in the cost of equity with the level of gearing is a straight line.
It is not risk that changes the capital structure. It is the capital structure that changes the risk!!
The business risk is the risk due to the nature of the business and is not affected by the capital structure. Changes in the capital structure (I,e, the gearing) affect the financial risk.
This is al explained in my free lectures on the effect of changes in gearing.
The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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