5. FinancingAssume that you live in the blissful world of perfect capital markets: there are notransaction costs or taxes; bankruptcy costs are zero; individuals can borrow and lend atthe same rate as corporations can; and all agents in the economy have the sameinformation. Let us compare two corporations that are identical except that one is allequity financed and the other is part equity and part debt financed. Denote the value ofthe unlevered (all equity) firm by u and the value of the levered firm by V. Assumethat= $20,000• the interest rate on the firm's debt is .10• the two firms generate identical net revenues of $1000 in good times and $400 in badtimes• the levered firm has $6,000 of debtA. Compute the cash flows accruing to an investor who borrows on her personal accountan amount equal to one percent of the debt of the levered firm and purchases onepercent of thé unlevered firm.B. Compute the cash flows of an investor who purchases one percent of the equity of thelevered firm.

With perfect capital market and without tax, the value of levered firm (VL) is equal to the value of…

Answered: Financing Assume that you live in the…

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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6. Financing Assume that you live in the blissful world of perfect capital markets: there are no transaction costs or taxes; bankruptcy costs are zero; individuals can borrow and lend at the same rate as corporations can; and all agents in the economy have the same information. Let us compare two corporations that are identical except that one is all equity financed and the other is part equity and part debt financed. Denote the value of the unlevered (all equity) firm by V and the value of the levered firm by V, . Assume that V, = $50,000 the interest rate on the firm's debt is .10 the firms generate identical net revenues of $8,000 in good times $1,000 in bad times the levered firm has $20,000 of debt A. Compute the cash flows accruing to an investor who borrows on her personal account an amount equal to one percent of the debt of the levered firm and purchases one percent of the unlevered firm, B. Compute the cash flows of an investor who purchases one percent of the equity of the…
1. Assume that capital markets are perfect: there are no transactions costs or taxes, no bankruptcy costs, individuals can borrow and lend at the same rate as corporations can, and all agents in the economy have the same information. Let us compare two corporations that are identical except that one is all equity financed and the other is part equity and part debt financed. Denote the value of the unlevered (all equity) firm by VU and the value of the levered firm by VL. Assume that • Vu = $20,000 • Interest rate on the firm's debt is .10 • The firms generate identical net revenues of $2000 in good times $500 in bad times • Levered firm has $5,000 of debt A. Compute the cash flows accruing to an investor who borrows on her personal account an amount equal to one percent of the debt of the levered firm and purchases one percent of the unlevered firm. B. Next compute the cash flows of an investor who purchases one percent of the equity of the levered firm. C. Using your results in parts…
1. Cost of money Everyone uses money, and it is important to understand what factors affect the cost of money. Consider the following scenario: A friend comes to you and asks you to invest in his business instead of investing in Treasury bonds. You think he has a good business model, so you tell him you are willing to invest as long as the expected return on the investment is at least four times the return you would have received on the Treasury bonds. Determine which of these fundamental factors is affecting the cost of money in the scenario described: Risk Inflation Time preferences for consumption
Under Modigliani and Miller's assumption of perfect capital markets, which of the following is NOT CORRECT? A) The proper WACC equation under perfect capital markets is the "pre-tax" WACC B) Taxes are irrelevant C) Reducing the debt ratio can cause the cost of debt and the cost of equity to decline, even as the WACC stays the same. D) The WACC does not change as the weights of debt and equity change E) Bankruptcy costs reduce the amount bondholders receive when bankruptcy occurs
7. The reason firms care about the amount of debt they use is because a. There are tax benefits to debt, so capital structure can affect the value of the firm b. Firms don't care about their amount of debt c. There are tax benefits of equity, so using debt can replace valuable equity d. None of the above 8. When an economy has a risk-free asset, all risk-averse investors should invest in either the risk-free asset or the highest Sharpe-ratio risky asset (or both) a. True b. False c. Too little information to tell d. None of the above 9. The CAPM equation (Security Market Line) is a useful tool when trying to identify a company's a. Weight Average Cost of Capital b. Required Return on Equity c. Expected Return on Equity d. All of the above
Select all that is not true about capital structure theory (MM theory). (2 answers) Under perfect capital market assumptions with no corporate tax, equity holder’s risk increases with leverage. Under perfect capital market assumptions with no corporate tax, cost of equity increases with leverage. Under perfect capital market assumptions with no corporate tax, there is an optimal capital structure that maximizes the firm value. Under perfect capital market assumptions with no corporate tax, cost of capital for all equity (unlevered) firm is equal to cost of capital for levered firm. Under perfect capital market assumptions with no corporate tax, cost of debt capital is higher than cost of equity capital.
Assume a Modigliani and Miller economy. Company XYZ is currently financed only withequity. The management of the company hires a consultant. The consultant makes thefollowing suggestion: “My advice for XYZ is to issue debt and use it to repurchase some ofthe company’s equity. This would allow XYZ to get the benefit of a low cost of capital ofdebt without raising its cost of capital of equity.”Discuss in detail the statement of the consultant.
According to the trade-off theory of capital structure which of the following statements is true (only one is): (a) The optimal capital structure is such that the marginal tax benefits from debt are equal to the marginal costs of bankruptcy. (b) There is no optimal capital structure. (c) More debt is always better as it increases tax shields. (d) More debt is always worse as it increases bankruptcy costs. (e) Retained earnings are the best financing method.
The Nobel Prize-winning Modigliani & Miller Theory states that a firm’s capital structure does not matter. It is based on three key assumptions: No income taxes Equal borrowing cost- individuals can borrow at the same interest rate as corporations. Perfect markets: There are no bankruptcy, transaction, contracting, or agency costs. Are these assumptions reasonable? What are the implications if the assumptions do not hold?
According to Modigliani and Miller Proposition II: A. WACC curve is flat and hence no optimal capital structure exists B. WACC curve is upward slopping , indicating the equity financing exclusively being the optimal capital structure of a company C. WACC curve is downward slopping, hence the perfect capital structure is 100% debt D. An optimal capital structure exists as it is the balance between the tax benefit and the bankruptcy costs
Which of the following statements is CORRECT? * Assume a corporation has less debt than what is ideal. Increasing the use of debt to reach its optimum capital structure would lower the cost of both debt and equity financing. There is no reason to believe that changes in the personal tax rate will have an effect on firms' capital structure decisions. Assuming everything else is equal, a firm with high business risk is more likely to increase the use of financial leverage than a firm with low business risk. In general, a company with low operating leverage has a small percentage of its total costs in the form of fixed costs. If a company's after-tax cost of equity exceeds its after-tax cost of debt, it can still lower its WACC by using more debt.
Capital structure is irrelevant if: I) capital markets are efficient; II) each investor can borrow/lend on the same terms as the firm; III) there are no tax benefits to debt Multiple Choice A) III only B) I only C) II only D) I, II, and III

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