Question

. Imagine a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to:

(a) The ratio of the market value of the equity to income after interest if M&M propositions are right?

(b) The ratio of the market value of the firm to income before interest if M&M propositions are right?

Answer 1

(a) The ratio of the market value of the equity to income after interest if M&M propositions are right?

No, MM propostion is not right.Cost of equity should be equal to opportunity cost of capital plus a financial risk premium.

(b) The ratio of the market value of the firm to income before interest if M&M propositions are right?

No, M&m Propositions are not right, As per MM approach, Total market value of the firm is equal to excepted net operating income. So value of the firm is netoperating income /Ko

Here Net operating income means earning before interest & tax.

Ko means average cost of capital