Question

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*.

Answer #1

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.

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?

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 we are in an otherwise perfect, frictionless world with
corporate taxes. Firm X has a debt-to-equity ratio of 2.25, its
cost of equity is 12%, and its cost of debt is 6%. The corporate
tax rate is 35%. If the firm converts to a debt-to-equity ratio of
1.25, what will its new WACC be?

______
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,...

Discuss Modigliani and Miller's Propositions I and II in a
perfect world without taxes nor distress costs. List the basic
assumptions, results, and intuition of the model. Based on this
model, if the original unlevered firm value is $100 million and the
CFO is planning to carry out a leveraged recapitalization to a debt
equity ratio of 1:1. What’s the levered firm value? If the
unlevered equity requires 10% annual return and the debt requires a
6% of annual return,...

For firms with relatively high levels of debt in perfect capital
markets (no taxes, no costs of financial distress), the cost of
capital is closer to the cost of debt capital than to the cost of
equity capital.
True
False

Luna Corporation has a beta of 1.5, £10 billion in equity, and
£5 billion in debt with an interest rate of 4%. Assume a risk-free
rate of 0.5% and a market risk premium of 6%. Calculate the WACC
without tax.
Queen Corporation has a debt-to-equity ratio of 1.8. If it had
no debt, its cost of equity would be 16%. Its current cost of debt
is 10%. What is the cost of equity for the firm if the corporate
tax...

Assume perfect capital markets. The table below gives the
probability distributions of a share of the Omega corporation and
the broad stock market.
State
S1
S2
S3
Probability
25%
50%
25%
Omega
-4%
1%
10%
Market
-3%
2%
5%
What is the expected return on the Omega share and on the Broad
stock Market?
What is the risk (standard deviation) of the Omega share and
the risk (standard deviation) of the Market?
What is the market beta of the Omega...

Assume a world in which the assumptions of the capital asset
pricing model (CAPM) hold. A company can invest in a project which
costs today $5,000, in one year delivers $2,000 with certainty and
in two years delivers -$1,000 with a probability of 25% and $8,000
with a probability of 75%. Suppose the annual risk free rate is 3%,
the expected return on the market is 10% and the project’s market
beta is 1.5. Should the company invest in the...

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