Modern capital structure theory, constructed by Modigliani and Miller, began in 1958 and provided a justification corporation's use of more and more financial leverage under certain assumptions. CEOS and CFOS were encoura to accept M&M's theory and put it into practice, especially when the company's spending is high and the risk of servicing its debt is low. As capital markets have evolved, it is critical to understand the context and assumption under which this model was created. Review the situation and answer the questions that follow: An analyst has graphed the relationship between the expected return on a firm's capital and its debt-equity (D/ ratio. Her graph follows: RATES OF RETURN (Percent) 20 18 16 "Equity 14 12 rAssets 10 8 "Debt 6 4 2
Modern capital structure theory, constructed by Modigliani and Miller, began in 1958 and provided a justification corporation's use of more and more financial leverage under certain assumptions. CEOS and CFOS were encoura to accept M&M's theory and put it into practice, especially when the company's spending is high and the risk of servicing its debt is low. As capital markets have evolved, it is critical to understand the context and assumption under which this model was created. Review the situation and answer the questions that follow: An analyst has graphed the relationship between the expected return on a firm's capital and its debt-equity (D/ ratio. Her graph follows: RATES OF RETURN (Percent) 20 18 16 "Equity 14 12 rAssets 10 8 "Debt 6 4 2
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
Related questions
Concept explainers
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.
Question
Transcribed Image Text:6. Assumptions of the Modigliani and Miller proposition
Aa Aa
Modern capital structure theory, constructed by Modigliani and Miller, began in 1958 and provided a justification for a
corporation's use of more and more financial leverage under certain assumptions. CEOS and CFOS were encouraged
to accept M&M's theory and put it into practice, especially when the company's spending is high and the risk of
servicing its debt is low. As capital markets have evolved, it is critical to understand the context and assumptions
under which this model was created.
Review the situation and answer the questions that follow:
An analyst has graphed the relationship between the expected return on a firm's capital and its debt-equity (D/E)
ratio. Her graph follows:
RATES OF RETURN (Percent)
20
18
16
"Equity
14
12
rAssets
10
8.
rDebt
6
2
0.0
0.5
1.0
1.5
2.0
DEBT-EQUITY D/E RATIO
Transcribed Image Text:0.0
0.5
1.0
1.5
2.0
DEBT-EQUITY D/E RATIO
From what you see on the graph, which of the following assumptions is consistent with the graph?
The cost of equity will always remain higher than the cost of debt.
Excessive financial leverage causes a decrease in the firm's EBIT.
The firm's debt is risk free.
The firm's debt has no default risk.
Based on the assumption that a firm operates in a tax-free world, Modigliani and Miller made an important
proposition about the value of a levered portfolio or company (VL) and an unlevered portfolio or firm (Vu). Which of
the following equations best represents the conclusion from the MM: No Tax theory?
Vu
SL - D
VL = SL = D
VL = SL + D
Vu # VL
Expert Solution
This question has been solved!
Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.
This is a popular solution!
Trending now
This is a popular solution!
Step by step
Solved in 2 steps
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Recommended textbooks for you
Essentials Of Investments
Finance
ISBN:
9781260013924
Author:
Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:
Mcgraw-hill Education,
Essentials Of Investments
Finance
ISBN:
9781260013924
Author:
Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:
Mcgraw-hill Education,
Foundations Of Finance
Finance
ISBN:
9780134897264
Author:
KEOWN, Arthur J., Martin, John D., PETTY, J. William
Publisher:
Pearson,
Fundamentals of Financial Management (MindTap Cou…
Finance
ISBN:
9781337395250
Author:
Eugene F. Brigham, Joel F. Houston
Publisher:
Cengage Learning
Corporate Finance (The Mcgraw-hill/Irwin Series i…
Finance
ISBN:
9780077861759
Author:
Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan Professor
Publisher:
McGraw-Hill Education