Chapter 17, Problem 5PS

MM’s propositions True or false?

1. a. MM’s propositions assume perfect financial markets, with no distorting taxes or other imperfections.
2. b. MM’s proposition 1 says that corporate borrowing increases earnings per share but reduces the price–earnings ratio.
3. 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.
4. d. MM’s proposition 2 assumes that increased borrowing does not affect the interest rate on the firm’s debt.
5. e. Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.
6. f. Borrowing always increases firm value if there is a clientele of investors with a reason to prefer debt.