Final answer:
Modigliani and Miller's Proposition II assumes that increased borrowing does not affect a firm's interest rate on debt, under ideal conditions. However, real-world complexities, such as those indicated by the Ricardian equivalence and laws of demand and supply, can result in changes in interest rates when these assumptions do not hold.
Step-by-step explanation:
Modigliani and Miller's Proposition II assumes that a firm's cost of equity capital is a linear function of its capital structure. Specifically, it posits that the required rate of return on equity increases as the firm leverages more (due to higher perceived risk), but that this does not change the cost of debt. This is under the assumption of no taxes and that capital markets operate perfectly, so increased borrowing does not affect the interest rate on the firm's debt.
The theory of Ricardian equivalence broadly relates to this concept. It suggests that government borrowing would be offset by changes in private saving, implying that if everyone acted rationally, this government borrowing wouldn't affect overall demand or interest rates. However, in practice, this doesn’t always hold true.
In a perfect market, an increase in loanable funds leads to a reduction in interest rates, as more suppliers of capital drive the price of borrowing down. The laws of demand and supply in financial markets denote that as interest rates rise, borrowers reduce demand, and as interest rates fall, the amount of financial capital supplied decreases. Thus, if Modigliani and Miller's assumption fails, increased corporate borrowing could indeed raise interest rates, altering investment and saving behaviors.