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%.

How would the cost of equity change if the company’s
debt-to-equity ratio rises 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%
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.

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?

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

______
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,...

Assume that capital markets are perfect. A firm finances its
operations via $50 million in stock with required return of 15% and
$40 million in bonds with a required return of 9%. Assuming that
the firm could issue $10 million in additional bonds at 9% and use
the proceeds to reture $10 million worth of equity, what would
happen to the firm’s WACC ? What would happen to the required
return on the company’s stock ?

The XYZ company currently has a debt-to-equity ratio of 20%.
Assume no taxes and perfect contracting.
1:If the XYZ company
decides to increase their debt-to-equity ratio to 40%, what will
happen to their cost of equity?
A:The cost of equity will stay the same
B:The cost of equity will go down
C:The cost of equity will go up
2:If the XYZ company
decides to increase their debt-to-equity ratio to 40%, what will
happen to their total cost of capital?
A:The...

Assume capital markets are perfect without frictions. Assume all
people are risk averse. Which of the following is true?
A. Higher leverage is good for the equity holders up until a
point. If leverage is too high, it starts being bad for
shareholders.
B. Risk of equity increases even if the company has very low
leverage ratio and increases leverage by just a little.
C. Higher leverage will not change the return on equity.
D. Higher leverage makes shareholders better...

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