Modigliani and Miller (1958): “The expected yield of a share of stock is equal to the appropriate
capitalization rate rk for a pure equity stream in the class, plus a premium related to financial risk equal to
the debt-to-equity ratio times the spread between rk and the risk-free rate.”
Discuss the notion of conservation of risk, reduction of risk in one area is offset by increased risk in another
area. As the firm makes capital structure changes, the total risk remains the same. Explain the effect on the
cost of equity with the addition of leverage, does the cost of equity increase, decrease or remain constant?
Why? What is the impact to the weighted cost of capital does it increase, decrease or remain constant?
Why?