Recently you have been invited to the Directors meeting to decide on the future capital structure for the firm. One of your colleagues came with the following argument: 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.

Using the argument of M&M Proposition I The market value of a company is independent of its

capital structure, suggest why this argument is not relevant, for simplicity ignore the tax implications.