PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Textbook Question
Chapter 17, Problem 5PS
MM’s propositions True or false?
- a. MM’s propositions assume perfect financial markets, with no distorting taxes or other imperfections.
- b. MM’s proposition 1 says that corporate borrowing increases earnings per share but reduces the price–earnings ratio.
- c. MM’s proposition 2 says that the
cost of equity increases with borrowing and that the increase is proportional to D/V, the ratio of debt to firm value. - d. MM’s proposition 2 assumes that increased borrowing does not affect the interest rate on the firm’s debt.
- e. Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.
- f. Borrowing always increases firm value if there is a clientele of investors with a reason to prefer debt.
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Check out a sample textbook solutionStudents have asked these similar questions
Assume that there is corporate tax, but no other frictions. Based on the propositions of Modigliani and Miller, which statement is the least accurate?
Oa. The weighted cost of capital decreases as the leverage ratio increases.
D. The cost of debt increases as the leverage ratio increases.
C. Firm value increases as the firm takes on more debts.
d. The cost of equity increases as the leverage ratio increases.
O e. The optimal structure is 100% debt.
Which of the following is true regarding a company assuming more debt?
Select one:
a. Assuming more debt is always bad for the company
b. Assuming more debt reduces leverage
c. Assuming more debt can be good for the company as long as they earn a return in excess of the rate charged on the borrowed funds
d. Assuming more debt is always good for the company
(b) Assume that Modigliani-Miller Propositions 1 and 2 hold. Ex-
plain carefully why the conclusion of each of the following argu-
ments is incorrect:
(i) As a firm borrows more and debt becomes risky, both share-
holder and bondholders demand higher rates of return. Thus,
by reducing its debt ratio, a firm can reduce both the cost
of debt and the cost of equity.
(ii) As leverage increases, the ratio of the market value of a firm's
equity to income (after debt interest) increases.
Chapter 17 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 17 - Homemade leverage Ms. Kraft owns 50,000 shares of...Ch. 17 - Homemade leverage Companies A and B differ only in...Ch. 17 - Corporate leverage Suppose that Macbeth Spot...Ch. 17 - Corporate leverage Reliable Gearing currently is...Ch. 17 - MMs propositions True or false? a. MMs...Ch. 17 - MMs propositions What is wrong with the following...Ch. 17 - Prob. 7PSCh. 17 - MM proposition 1 Executive Cheese has issued debt...Ch. 17 - Prob. 9PSCh. 17 - Prob. 10PS
Ch. 17 - MM proposition 2 Spam Corp. is financed entirely...Ch. 17 - MM proposition 2. Increasing financial leverage...Ch. 17 - Prob. 13PSCh. 17 - MM proposition 2 Look back to Section 17-1....Ch. 17 - MM proposition 2 Hubbards Pet Foods is financed...Ch. 17 - MM proposition 2 Imagine a firm that is expected...Ch. 17 - MM proposition 2 Archimedes Levers is financed by...Ch. 17 - MM proposition 2 Look back to Problem 17. Suppose...Ch. 17 - Prob. 19PSCh. 17 - After-tax WACC Gaucho Services starts life with...Ch. 17 - After-tax WACC Omega Corporation has 10 million...Ch. 17 - After-tax WACC Gamma Airlines has an asset beta of...Ch. 17 - Prob. 23PSCh. 17 - Investor choice People often convey the idea...Ch. 17 - Investor choice Suppose that new security designs...
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- For each statement indicate whether it is true or false and briefly explain why. a) In a perfect capital market with no corporate taxes, as a firm takes on more and more debt its weighted average cost of capital remains unchanged while its required return on equity rises. b) If a firm issues riskfree debt the risk of the firm’s equity will not change. So, risk-free debt allows the firm to get the benefit of a low cost of debt without raising its cost of equity. c) In the context of firms’ capital structure decisions, the theory predicts that the value of a firm’s equity will rise in direct proportion to the level of debt in its capital structure.arrow_forwardM&M Proposition I, without taxes, is referred to as the pie model. Explain why the size of the pie remains constant as the debt-equity ratio of a firm increases.arrow_forwardWhich of the following statements are CORRECT? Check all that apply: The aftertax cost of debt decreases when the market price of a bond increases. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options. Cost of capital is also known as the minimum expected or required return an investment must offer to be attractive.arrow_forward
- Which of the following statements is FALSE? Question content area bottom Part 1 A. Growth rate of the firm is higher, it is more optimal to have a higher level of debt relative to equity in the firm capital structure. B. Growth will affect the optimal leverage ratio even if the firm has positive earnings. C. When examining tax, the optimal debt level is proportional to its current earnings. D. The more unsure we are of EBIT the more chance that interest will exceed EBIT, if the interest expense is higharrow_forward2. The Trade-Off Model A. "The trade-off model of debt financing implies that an increase in the interest rate on debt will cause the level of debt to decline." Do you agree or disagree? Please explain. B. Discuss the likely effects of an increase in uncertainty about cash flows on the responsiveness of a firm's debt level to changes in the interest rate on debt.arrow_forward2) Which one of these statements corresponds to MM proposition I without taxes? A) Debt interest reduces equity income and increases firm value. B) The value of a firm increases as its debt-equity ratio increases. C) Debt interest has no effect on either equity income or firm value. D) Debt interest reduces equity income but does not affect firm value.arrow_forward
- Which of the following statements is CORRECT?a.The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.b.The capital structure that maximizes the stock price is generally the capital structure that also maximizes its WACC.c.The capital structure that maximizes the stock price is generally the capital structure that also minimizes its WACC.d.Since debt is cheaper than equity, increasing the debt ratio will always reduce WACC.e.When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.arrow_forwardIndicate whether each of the following statements is true or false. Support vour answers with relevant explanations.A) Modigliani and Miller's Proposition II assumes that increased borrowin does not afffect the interest rate on the firm's debt.B) Under the conditions of perfect capital markets the cost of capital of a company financed fully by equity is expected to be equal to that of the same company but financed with 50% equity and 50% debt. C) The higher the systematic risk of a company's stock, the higher the value of its beta. The higher the beta, the higher the return required by investors.arrow_forwardBoth EV-to-EBITDA and PE multiples can be linked to interest rates through the discount rate used in discounted cash flow valuation. Holding all else equal, when discount rates are higher, valuation ratios are lower. Perhaps because of this, we tend to see stock prices as well as, the value of private business transactions decline when interest rates increase. Macroeconomists like to describe interest rates as consisting of two components: the real interest rate component and an expected inflation component. In some situations, increases in interest rates are the result of an increasing real interest rate; in other situations, the cause of an interest rate increase is an increase in expected inflation. How might valuation ratios be expected to respond to an interest rate increase generated by an increase in expected inflation versus an interest rate increase that represents an increase in real interest rates?arrow_forward
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