If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, r_s, than on the interest rate on long-term debt, r_d, for most firms.Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity.However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

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Quizplus · Accepted Answer

This statement is true as the slope of the SML affects the required rate of return on equity more than on long-term debt. This would lead to an increase in the use of debt and decrease in the use of equity, but this shift towards debt would also increase the riskiness of both debt and equity and limit the overall impact.

If Investors' Aversion to Risk Rose, Causing the Slope of the SML