THE AMERICAN ECONOMIC REVIEW sources-must be the same for all firms in a given class. 8 In other words the increased cost of borrowed funds as leverage increases will tend to be offset by a corresponding reduction in the yield of common stock This seemingly paradoxical result will be examined more closely below in connection with Proposition II A significant modification of Proposition I would be required only if might happen if creditors had marked preferences for the securities or R. the yield curve r=r(D/S) were different for different borrowers particular class of debtors. If, for example, corporations as a class were able to borrow at lower rates than individuals having equivalent per sonal leverage, then the average cost of capital to corporations might all slightly, as leverage increased over some range, in reflection of this differential. In evaluating this possibility, however, remember that the relevant interest rate for our arbitrage operators is the rate on brokers' loans and, historically, that rate has not been noticeably higher than representative corporate rates. 9 The operations of holding and investment trusts which can borrow on terms comparable to operat ing companies represent still another force which could be expected to wipe out any marked or prolonged advantages from holding levered Although Proposition I remains unaffected as long as the yield curve is the same for all borrowers, the relation between common stock yields and leverage will no longer be the strictly linear one given by the original Proposition II. If r increases with leverage, the yield i will still tend to 18 One normally minor qualification might be noted. Once we relax the assumption that all bonds have certain yields, our arbitrage operator faces the danger of something comparable to gambler's ruin "That is, there is always the possibility that an otherwise sound concern- ne whose long-run expected income is greater than its interest liability--might be forced in liquidation as a result of a run of temporary lo tion with lasting ne e operation of the firm may be hampered during the period of reorganiza- vorable effects on earnings prospects, we might perhaps expect heav levered companies to sell at a slight discount relative to less heavily indebted companies of th xpected to take the form, not of having the arbitrage operators go into debt on personal account to put the required leverage into their portfolios, but simply of having them reduce ne amount of corporate bonds they already hold when they acquire underpriced unlevered ock. Margin requirements are also somewhat less of an obstacle to maintaining any desired ored in the face of highe folio than might be thought at first glance. Leverage could be her margin requirements by switching to stocks hay 20 An extreme form of inequality between borrowing and lending rates occurs, of course, in the case of preferred stocks, which can not be directly issued by individuals on personal however, we would expect that the operations of investment e prevent the emergence of any substantial premiums for this aining preferred stocks. Nor are preferred stocks so far removed onds as to make it impossible for arbitrage operators to approrimate closely the risk and leverage of a corporate preferred stock by incurring a somewhat smaller debt on personal account