Question

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

Answer #1

*ANSWER*

*- CORRECT ANSWER : TRUE*

*- EXPLANATION :*

*The Overall cost of Capital of a Firm is the Weighted Average Cost of Capital .**So in case of Perfect Capital Markets where there are No taxes and No other transaction cost , the cost of debt itself becomes the final Cost of Debt (ie after taxes) without any change.**So in such a case when we will increase the Weight of Debt in the Capital Structure of the Firm, the Overall Cost will start getting closer to the Cost of Debt itself due to its higher weight.*

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 statements is false
if capital markets have both taxes and financial distress as the
market imperfections?
A.
If two firms are identical but differ only in their capital
structure, then the value of the levered firm is higher than the
value of the unlevered firm by the present value of the interest
tax shield
B.
There is an optimal capital structure that can maximize firm
value
C.
The capital structure choice considers a trade-off between the
tax...

firms whose
assets are relatively low bankrupt cost, hence they tend to use
relatively more debt.
true or
false
firms whose asset are relative liquid tend to have relatively low
bankruptcy costs, hence they temd to use relatively more debt

Piedmont Instruments Corporation has estimated the following
costs of debt and equity capital for various fractions of debt in
its capital structure.
ke with Financial Distress
Costs
ke with Financial
Debt fraction
ki
and Without Agency Costs
Costs and Agency Costs
0.00
—
12.00
%
12.00
%
0.10
4.8
%
12.05
12.05
0.30
4.9
12.10
12.20
0.40
5.0
12.20
12.60
0.45
5.2
12.40
13.40
0.50
5.7
12.80
14.80
0.60
7.2
15.00
18.00
Based on these data, the company’s optimal capital...

If we extend the MM's framework by corporate taxes (but no
distress costs) then
a) Equity becomes more attractive because it is subject to
corporate tax and we can take advantage of the tax shield
b) Interest payments on debt are tax deductible which increases
the Weighted average cost of capital for high levels of debt
relative to the standard MM framework
c) The present value of future tax savings increases the market
value of the firm
d) More than...

Firms A and B are identical except for their capital structure.
A carries no debt, whereas B carries £40m of debt on which it pays
a 5% interest rate. Assume no transaction costs, no taxes and
risk-free debt. The relevant numbers are provided in the following
table (in £ m):
A
B
Value of Firm
Debt
0 40
Equity
100
80
Earnings before
interest 10 10
Interest payment
Interest
rate
Not
Applicable
5%
Earnings after interest
Return on Equity
Debt/Equity Ratio
Cost...

The TQM Corporation is
located in a country where there are perfect capital markets and no
taxes. The corporation currently has $120 million in equity and $60
million in risk free debt. The return on equity, rS, is 18% and the
cost of debt, rB, is 9%. Suppose TQM decides to issue additional
equity to repurchase the $60 million in debt so that it will have
an all-equity capital structure.1. If TQM did this, what would the total value of...

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?

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?

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