Question

In perfect and complete markets Miller and Modigliani (1958) show that there is no advantage to debt vs equity in the capital structure. That is, the value of the firm is determined by its income from operations, not from its capital structure.

What do Miller and Modigliani mean by perfect and complete markets?

How did their argument change with the introduction of corporate taxes into their model?

Answer #1

According to the hypothesis, a perfect market is the one where,

- No investor can cause any significant changes to the the market price of shares
- There are no costs incurred for buying and selling of shares
- There are no transaction costs
- Information is easily and freely available to each investor

Imperfections arise in the markets when corporates are subject to taxes. Interest payable on debt can be deducted for tax purposes. However dividends and Retained profits do not enjoy such a benefit. Thus, the firm prefers employing debt so that they can enjoy benefits of leverage. Moreover the value of the levered firm will exceed the unlevered firm by an amount equal to the debt multiplied by the rate of tax.

In perfect and complete markets Miller and Modigliani (1958)
show that there is no advantage to debt vs equity in the capital
structure. That is, the value of the firm is determined
by its income from operations, not from its capital structure.
What do MM mean by perfect and complete markets?
How did their argument change with the introduction of corporate
taxes into their model?

Assume that Modigliani and Miller’s perfect capital markets
assumptions hold and there are no corporate taxes. A company’s cost
of debt is 10%, its cost of equity is 25% and its debt-to-equity
ratio is 25%.
How would the cost of equity change if the company’s
debt-to-equity ratio rises to 50%? Show your
calculations.

Assume that Modigliani and Miller’s perfect capital markets
assumptions hold and there are no corporate taxes. A company’s cost
of debt is 10%, its cost of equity is 25% and its debt-to-equity
ratio is 25%
Assume that the riskfree rate is 10% and the market risk premium
is 7.5%. How has the company’s equity beta changed with the
debt-to-equity ratio changing from 25% to 50%? Show your
calculations.

Which of the following statement is true regarding the
Modigliani and Miller (M&M) propositions (1958) in a perfect
financial market?
A) Capital structure is irrelevant because of the assumption
that investors and companies have differing tax rates.
B) It is assumed that the firm’s future cash flows remain fixed
under any circumstances.
C) The basic lesson of M&M propositions is that company’s
capital budgeting decisions are dependent upon the company's
capital structure decision.
D) The debt-to-equity ratio is an important...

Which of the following statements is FALSE?
A. Franco Modigliani and Merton Miller argued that with perfect
capital markets, the total value of a firm should not depend on its
capital structure.
B. Because the cash flows of the debt and equity sum to the cash
flows of the project, by the Law of One Price the combined values
of debt and equity must be equal to the cash flows of the
project.
C. Leverage decreases the risk of the...

1- Under the theory of Modigliani & Miller without taxes,
which of the following statements is false?
a) The capital structure is irrelevant.
b) The cost of equity is a linear function of the equity-to-debt
ratio.
c) The value of the levered company is equal to the value of the
unlevered company.
d) The cost of equity increases as the debt-to-equity ratio
increases.
2 - Which of the following statements is true regarding the
pecking order theory?
a) The external...

The basic point being made by Modigliani and Miller is that in
the absence of taxes and transaction costs
1. the optimal capital structure balances the firm’s tax-shield
and financial distress costs.
2. a firm cannot change the total value of its outstanding
securities by changing its capital structure
3. greater debt leads to a lower weighted-average cost of
capital and greater firm value.
4. we must account for the timing and risk of cash flows in
order to properly...

______
3. If markets are perfect (and using
the other assumptions in Miller and Modigliani (1961)), stock
prices should fall by the amount of a cash dividend. If so, can a
firm make its stockholders wealthier by changing (i.e., increasing
or decreasing) its dividend?
A. No, under these assumptions, a firm
cannot make its stockholders wealthier by changing its
dividend.
B. Yes, under these assumptions, a
firm can make its stockholders wealthier, but only by increasing
its dividend.
C. Yes,...

According to the Modigliani-Miller theorem, a firm’s value is
independent of its capital structure assuming no taxes or
bankruptcy costs. Describe how changing these assumptions (i.e.,
assume a firm faces taxes with and without bankruptcy costs)
influences its choice of capital structure and provide examples of
bankruptcy costs.

Answer the problem based on the framework of Modigliani and
Miller Propositions. Assume that a company has earnings before
interest and taxes (EBIT) of $1,000,000 every year forever. The
firm also has perpetual bonds with the market value of $2,000,000.
The before-tax cost of debt is 8 percent. The firm’s unlevered cost
of capital is 15 percent. The tax rate is 25 percent.
a) Find the value of the firm.
b) Find the value of equity.
c) Find the firm’s...

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