Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
12th Edition
ISBN: 9781259144387
Author: Richard A Brealey, Stewart C Myers, Franklin Allen
Publisher: McGraw-Hill Education
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Chapter 17, Problem 15PS
MM’s propositions What is wrong with the following arguments?
- a. As the firm borrows more and debt becomes risky, both stock- and bondholders demand higher
rates of return . Thus, by reducing the debt ratio, we can reduce both the cost of debt and thecost of equity , making everybody better off. - b. Moderate borrowing doesn’t significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won’t increase the expected rate of return demanded by stockholders.
- c. A capital investment opportunity offering a 10%
internal rate of return is an attractive project if it can be 100% debt-financed at an 8% interest rate. - d. The more debt the firm issues, the higher the interest rate it must pay. That is one important reason that firms should operate at conservative debt levels.
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Suppose company Z is already in financial distress and the equity holders are very close to default. Suddenly there is a shock that causes an increase in the standard deviation of the return on company Z's assets. Which of the following correctly describes the new situation faced by company Z?
A) Debt value will increase with the shock and equity holder are more likely to default.
B) Equity value will increase with the shock and equity holder are less likely to default.
C) Both Debt value and equity value will increase but the likelihood of default is unchanged.
D) Both debt value and equity value will decrease and the likehood of default will increase.
(b) Assume that Modigliani-Miller Propositions 1 and 2 hold. Ex-
plain carefully why the conclusion of each of the following argu-
ments is incorrect:
(i) As a firm borrows more and debt becomes risky, both share-
holder and bondholders demand higher rates of return. Thus,
by reducing its debt ratio, a firm can reduce both the cost
of debt and the cost of equity.
(ii) As leverage increases, the ratio of the market value of a firm's
equity to income (after debt interest) increases.
8. Which of the following does the trade-off theory predict? A. Bankruptcy costs
mean having no debt is always optimal. B. Reducing leverage always reduces
firm value. C. In the long run the firm's capital structure converges to the optimal
one. D. None of the above.
Chapter 17 Solutions
Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
Ch. 17 - Homemade leverage Ms. Kraft owns 50,000 shares of...Ch. 17 - MM proposition 2 Spam Corp. is financed entirely...Ch. 17 - Prob. 3PSCh. 17 - Corporate leverage Suppose that Macbeth Spot...Ch. 17 - MMs propositions True or false? a. MMs...Ch. 17 - MM proposition 2 Look back to Section 17-1....Ch. 17 - Prob. 8PSCh. 17 - Homemade leverage Companies A and B differ only in...Ch. 17 - Prob. 10PSCh. 17 - Prob. 11PS
Ch. 17 - MM proposition 1 Executive Cheese has issued debt...Ch. 17 - MM proposition 2 Hubbards Pet Foods is financed...Ch. 17 - Prob. 14PSCh. 17 - MMs propositions What is wrong with the following...Ch. 17 - Prob. 16PSCh. 17 - Prob. 17PSCh. 17 - MM proposition 2 Imagine a firm that is expected...Ch. 17 - MM proposition 2 Archimedes Levers is financed by...Ch. 17 - Prob. 20PSCh. 17 - Prob. 21PSCh. 17 - Prob. 22PSCh. 17 - Prob. 23PSCh. 17 - Investor choice People often convey the idea...Ch. 17 - Investor choice Suppose that new security designs...
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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.Similar questions
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- Which of the following statements is CORRECT? * In most cases, increasing a company's debt ratio raises the marginal cost of both debt and equity funding. However, this action could also reduce the company's WACC. Since debt funding is less costly than equity financing, rising a company's debt ratio would often lower its WACC. Since the use of financial leverage has no impact on a firm's beta coefficient, leverage has no effect on the cost of equity. Since debt funding increases a company's financial risk, raising its debt ratio will often increase its WACC. In most situations, rising a company's leverage ratio reduces the marginal cost of both debt and equity funding. However, this behavior could increase the company's WACC.arrow_forwardRegarding the EPS fallacy, which of the following statements is correct: a. When a company issues debt and uses all the proceeds to buy back equity and as a result EPS rises, the fact that some analysts associate the rise of EPS to an improvement in the company's performance is called the EPS fallacy. b. All given statements are correct. c. One of the reasons behind the EPS fallacy is not to take into account that when EPS rises mechanically due to a leveraged recapitalisation, the cost of equity also rises in the same proportion and the share price does not change (assume no taxes and perfect capital markets world). d. Suppose companies A and B have identical cash flows but different capital structures. Suppose further that EPS(A) > EPS(B). We cannot conclude that A has a better performance than B.arrow_forwardWhich of the following statements is correct? A. Investors appreciate illiquid assets in their portfolios as they can easily sell them off to cover margin calls. B. Liquid assets can quickly be converted into cash without changing prices too much. O C. Corporate bonds are among the most liquid financial assets as they trade at a very high frequency. D. Liquid assets tend to be cheaper as investors are not willing to pay for their liquidity benefits.arrow_forward
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