2. M&M propositions [LO 16.1] How would you answer in the following debate?

1. Q:

Is not it true that the riskiness of a firm’s equity will rise if the firm increases its use of debt financing?

2. A:

Yes, that is the essence of M&M Proposition II.

1. Q:

And is not it true that, as a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the risk of the firm’s debt?

2. A:

Yes.

3. Q:

In other words, increased borrowing increases the risk of the equity and the debt?

4. A:

That is right.

5. Q:

Well, given that the firm uses only debt and equity financing, and given that the risks of both are increased by increased borrowing, does it not follow that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm?

6. A:

?