It has been shown that a firm's beta ____ an increase in its degree of financial leverage.
A) increases with
B) decreases with
C) remains constant with
D) is not related to

Question

Quizplus · Accepted Answer

According to the Modigliani-Miller capital structure irrelevance theorem, a firm's beta, which represents the systematic risk of a stock, is not affected by changes in its capital structure or financial leverage. However, in the real world, there are factors such as taxes and bankruptcy costs that can impact a firm's beta as it increases its level of debt financing. Specifically, when a firm takes on more debt, it has a higher fixed interest expense, which makes its earnings more sensitive to fluctuations in revenue and overall market conditions. As a result, the firm's beta is likely to increase as it increases its degree of financial leverage.

It Has Been Shown That a Firm's Beta ____ an Increase