Question

According to MM proposition II, as debt increases. the firm's return on assets remains constant even while its return on equity increases. This is possible because as the return on equity increases, the amount of equity in the capital structure _______.

Answer 1

decreases

Step-by-step explanation:

As per modigliani- miller approach, the value of a firm is not dependent upon the choice of capital structure of the firm.

Capital structure refers to the the blend or mix of different sources of capital a firm avails to raise funds. Such as debt and equity.

As per MM proposition 2, the expected yield of a stock is equal to equity capitalization rate plus an additional compensation for risk assumed by employment of debt in the capital structure due to which the debt-equity ratio rises.

As proportion of debt is increased in the capital structure, the earnings available to stockholders rise but this rise is offset by the rise in the expectation of shareholders which offsets the effect and thus value of firm remains the same.

Return on equity is given by
`(net\ income)/(stockholders\ equity)`

Thus, as the return on equity increases , the amount of equity in capital structure decreases as this net income rises owing to employment of more and more debt in the capital structure.