Modern capital structure theory, constructed by Modigliani and Miller, began in $1958$ and provided a justification for a corporation$$s use of more and more financial leverage under certain assumptions. CEOs and CFOs were encouraged to accept M&M$$s theory and put it into practice, especially when the company$$s spending is high and the risk of servicing its 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:

From what you see on the graph, which of the following assumptions is consistent with the graph?

a$.$ The firm$$s debt has no default risk.

b$.$ Excessive financial leverage causes equity to become less risky than debt.

c$.$ Excessive financial leverage causes a decrease in the firm$$s EBIT.

d$.$ If leverage increases, the cost of equity increases enough to keep the weighted average cost of capital constant.