Question

In the context of a firm's capital structure decisions, a famous proposition by Modigliani and Miller implies the following relationship: PE=+(-5) Identify the proposition and explain each of the components in the expression above. Provide an intuitive interpretation of this proposition.

Answer 1

1]	The proposition is Modigliani Millers-Proposition II.
2]	rE = Cost of levered equity
	rO = Cost of ulevered equity
	rD = Cost of debt
	D/E = Debt to equity ratio
3]	The proposition states that a company's cost of
	equity is directly proportional to the extent of debt
	[leverage] in its capital structure. Higher level of debt
	increase the probability of bankruptcy and hence, the
	equity investors tend to demand higher return.