Given that rational investors are risk averse, the cost of debt will generally be lower than the cost of equity; however, M&M Proposition I states that replacing equity with debt will not change the value of the firm. Explain.

The student is asked to demonstrate his/her understanding of the basic M&M model. The astute student will recognize that, in terms of logical consistency, M&M is "bulletproof"; i.e., given the assumptions, you will arrive at M&M's conclusions -- period. Second, no one believes that the Case I model accurately describes reality; rather, it provides a jumping off point from which we can readily assess the importance of market "imperfections" such as taxes, bankruptcy costs, etc. One would hope that the responses to this question reflect these aspects of the issue, as well as the basic mechanics involved.