Indicate what’s wrong with the following arguments:

a. “As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.”

b. “Moderate borrowing doesn’t significantly affect the probability of financial distress or bankruptcy. Consequently moderate borrowing won’t increase the expected rate of return demanded by stockholders.”

Visit us at www.mhhe.com/bma 438 Part Five Payout Policy and Capital Structure AppendixLO1