PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Textbook Question
Chapter 17, Problem 5PS
MM’s propositions True or false?
- a. MM’s propositions assume perfect financial markets, with no distorting taxes or other imperfections.
- b. MM’s proposition 1 says that corporate borrowing increases earnings per share but reduces the price–earnings ratio.
- c. MM’s proposition 2 says that the
cost of equity increases with borrowing and that the increase is proportional to D/V, the ratio of debt to firm value. - d. MM’s proposition 2 assumes that increased borrowing does not affect the interest rate on the firm’s debt.
- e. Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.
- f. Borrowing always increases firm value if there is a clientele of investors with a reason to prefer debt.
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Indicate whether each of the following statements is true or false. Support your answers with the relevant explanations.
Modigliani and Miller’s Proposition II assumes that increased borrowing does not affect the interest rate on the firm’s debt. (Explain your reasoning.)
Under the conditions of perfect capital markets, the cost of capital of a company financed fully by equity is expected to be equal to that of the same company but financed with 50% equity and 50% debt. (Explain your reasoning.)
3. The higher the systematic risk of a company’s stock, the higher the value of its beta. The higher the beta, the higher the return required by the investors. (Explain your reasoning.)
4. The higher the proportion of equity in a company’s overall capital structure, the higher return required by its debtholders. (Explain your reasoning – in your explanation, provide a numerical example supporting your answer.)
5.In the presence of corporate taxes, a company would prefer to raise…
Indicate whether each of the following statements is true or false. Support your answers with the relevant explanations.
a) Modigliani and Miller’s Proposition II assumes that increased borrowing does not affect the interest rate on the firm’s debt. (Explain your reasoning.)
b) Under the conditions of perfect capital markets, the cost of capital of a company financed fully by equity is expected to be equal to that of the same company but financed with 50% equity and 50% debt. (Explain your reasoning.)
c) The higher the systematic risk of a company’s stock, the higher the value of its beta. The higher the beta, the higher the return required by the investors. (Explain your reasoning.)
For each statement indicate whether it is true or false and briefly explain why.
a) In a perfect capital market with no corporate taxes, as a firm takes on more and more debt its weighted average cost of capital remains unchanged while its required return on equity rises.
b) If a firm issues riskfree debt the risk of the firm’s equity will not change. So, risk-free debt allows the firm to get the benefit of a low cost of debt without raising its cost of equity.
c) In the context of firms’ capital structure decisions, the theory predicts that the value of a firm’s equity will rise in direct proportion to the level of debt in its capital structure.
Chapter 17 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 17 - Homemade leverage Ms. Kraft owns 50,000 shares of...Ch. 17 - Homemade leverage Companies A and B differ only in...Ch. 17 - Corporate leverage Suppose that Macbeth Spot...Ch. 17 - Corporate leverage Reliable Gearing currently is...Ch. 17 - MMs propositions True or false? a. MMs...Ch. 17 - MMs propositions What is wrong with the following...Ch. 17 - Prob. 7PSCh. 17 - MM proposition 1 Executive Cheese has issued debt...Ch. 17 - Prob. 9PSCh. 17 - Prob. 10PS
Ch. 17 - MM proposition 2 Spam Corp. is financed entirely...Ch. 17 - MM proposition 2. Increasing financial leverage...Ch. 17 - Prob. 13PSCh. 17 - MM proposition 2 Look back to Section 17-1....Ch. 17 - MM proposition 2 Hubbards Pet Foods is financed...Ch. 17 - MM proposition 2 Imagine a firm that is expected...Ch. 17 - MM proposition 2 Archimedes Levers is financed by...Ch. 17 - MM proposition 2 Look back to Problem 17. Suppose...Ch. 17 - Prob. 19PSCh. 17 - After-tax WACC Gaucho Services starts life with...Ch. 17 - After-tax WACC Omega Corporation has 10 million...Ch. 17 - After-tax WACC Gamma Airlines has an asset beta of...Ch. 17 - Prob. 23PSCh. 17 - Investor choice People often convey the idea...Ch. 17 - Investor choice Suppose that new security designs...
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- 5. Consider the following two potential transactions: (i) borrow from a bank; and (ii) use the proceeds from borrowing to pay out dividend. Assume this is an NFA firm. The combination of two financial transactions will A. reduce the financial leverage (FLEV) and the firm will continue to be an NFA firm.B. reduce the financial leverage (FLEV) and the firm will switch to an NFO firm.C. increase the financial leverage (FLEV) and the firm may become be an NFO firm.D. increase the financial leverage (FLEV) and the firm cannot be an NFA firm anymore.arrow_forwardExplain Why you agree or disagree with the following statements. The answer should not be more than 3 sentences. Be specific in your answer and write only the most relevant explanations. Treasury bills are riskier than corporate bonds A firm should select the capital structure that is fully unlevered. Leveraged beta represents fundamental financial risk. MM Proposition I with no tax supports the argument that a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.arrow_forwardPlease say whether each of the following statements is true or false. For each statement, give reasons in one or two sentences.1. In a Modigliani and Miller world with corporate taxes, the cost of capital is decreasing in the debt to equity ratio.2. In a Modigliani and Miller world with no taxes, dividends should be paid out only if the firm has free cash flows.3. Covenants on corporate bonds are a way in which bondholders protect their investment from moral hazard.4. Most of the gains generated by private equity investments tend to go to the shareholders of the target company.5. In an incentive compatible contract, the share of profits given to the agent is decreasing in the strength of the conflict of interest between the principal and the agent.6. Keeping capital structure constant, a company’s cost of capital is increasing in the beta of its shares.7. According to the Trade-off theory, firms with uncertain cash flows can afford to carry more debt.8. In a Modigliani-Miller world…arrow_forward
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