HW12_Answers - Q12-3 A12-3 What is the basic conclusion of...

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Q12-3. What is the basic conclusion of the original Modigliani and Miller Proposition I? A12-3. Miller and Modigliani Proposition I concludes that capital structure doesn’t matter – a firm has the same value whether it is unlevered or highly levered. Q12-6. By introducing personal taxes into the model for capital structure choice, how did Miller alter the previous M&M conclusion that 100 percent debt is optimal? What happens to the gains from leverage if personal tax rates on interest income are significantly higher than those on stock-related income? A12-6. The existence of personal taxes decreases the value of the corporate tax shield under current tax rates. It is theoretically possible for the combination of corporate tax rates, personal tax rate on debt income and personal tax rate on equity income to lead to the result that capital structure is irrelevant (the original M&M theory). It would also be theoretically possible for there to be a negative tax shield associated with debt financing, again depending on the relationship among the three tax rates. If personal tax rates on interest income are higher, relative to taxes on equity related income, then there will be less demand for debt financing. Firms that want to attract new debt financing will have to offer higher interest rates to attract investors. Q12-8. All else equal, which firm would face a greater level of financial distress, a software- development firm or a hotel chain? Why would financial distress costs affect the firms so differently? A12-8. A software development firm would face higher costs of financial distress than the hotel chain. The main asset of the software development firm is the expertise of its programmers, an intangible asset. The hotel chain’s assets are its hotel properties. A lender can repossess and sell physical assets like hotels; it cannot repossess and sell human capital. In distress, the software company’s programmers may jump ship and move to another, healthier software business, and the firm will lose even more in value as its human assets leave. A12-15. Corporate and personal taxes do influence capital structures, but are not the only factors that explain differences in capital structures. For example, U.S. corporations used no less debt before income taxes were introduced in 1913 than after 1913. Taxes peaked in the World War II period, yet book values of debt were at their lowest. Market values of debt rose from 1951 to 1973 and then declined. In other words there have been gradual changes in leverage, even though the tax law changes tend to be sudden. Research has shown that increases in corporate taxes are associated with increased debt usage and decreases in the personal tax rates on equity income relative to personal taxes on interest income are associated with less debt in capital structures.
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