Modern capital structure theory, constructed by Modigliani and Miller, began in 1958 and provided justifications for increasing leverage under certain assumptions. CEOs and CFOs were encouraged to adopt this theory into practice, especially when spending is high and the risk of servicing debt is low. As capital markets have evolved, it is critical to understand the context and assumptions under which this model was created. Review the situation and answer the questions that follow: An analyst has graphed the relationship between the expected return on a firm's capital and its debt-equity (D/E) ratio. Her graph follows: RATES OF RETURN Percent 20 18 16 14 12 10 rEquity WACC Debt 0.0 1.0 DEBT-EQUITY ID/EI RATIO 2.0 From what you see on the graph, which of the following assumptions is consistent with the graph? O The firm's debt is risk free O The cost of equity will always remain higher than the cost of debt. O Excessive financial leverage causes a decrease in the firm's EBIT (earnings before interest and taxes). O The firm's debt has no default risk. Based on the assumption that a firm operates in a tax-free world, Modigliani and Miller made an important proposition about the value of a levered portfolio (V.) and an unlevered portfolio (Vu). Which of the following equations best represents the conclusion from the MM: No Tax theory