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.)
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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.)
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Please answer the following follow up questions
Indicate whether each of the following statements is true or false. Support your answers with the relevant explanations.
d) 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.)
e) In the presence of corporate taxes, a company would prefer to raise debt only
when the benefits of the tax shield fully offset the cost of debt. (Explain your
reasoning – in your explanation, provide a numerical example supporting your
answer.)
f) In the presence of bankruptcy risk, the cost of capital of a company with debt is always higher than the cost of capital of an unlevered company. (Explain your
reasoning – in your explanation, provide a numerical example supporting your
answer.)
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