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CHAPTER 16 CAPITAL STRUCTURE: BASIC CONCEPTS Answers to Concepts Review and Critical Thinking Questions 1. Assumptions of the Modigliani-Miller theory in a world without taxes: 1) Individuals can borrow at the same interest rate at which the firm borrows. Since investors can purchase securities on margin, an individual’s effective interest rate is probably no higher than that for a firm. Therefore, this assumption is reasonable when applying MM’s theory to the real world. If a firm were able to borrow at a rate lower than individuals, the firm’s value would increase through corporate leverage. As MM Proposition I states, this is not the case in a world with no taxes. 2) There are no taxes. In the real world, firms do pay taxes. In the presence of corporate taxes, the value of a firm is positively related to its debt level. Since interest payments are deductible, increasing debt reduces taxes and raises the value of the firm. 3) There are no costs of financial distress. In the real world, costs of financial distress can be substantial. Since stockholders eventually bear these costs, there are incentives for a firm to lower the amount of debt in its capital structure. This topic will be discussed in more detail in later chapters. 2. False. A reduction in leverage will decrease both the risk of the stock and its expected return. Modigliani and Miller state that, in the absence of taxes, these two effects exactly cancel each other out and leave the price of the stock and the overall value of the firm unchanged. 3. False. Modigliani-Miller Proposition II (No Taxes) states that the required return on a firm’s equity is positively related to the firm’s debt-equity ratio [R S = R 0 + (B/S)(R 0 – R B )]. Therefore, any increase in the amount of debt in a firm’s capital structure will increase the required return on the firm’s equity. 4. Interest payments are tax deductible, where payments to shareholders (dividends) are not tax deductible. 5. Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely to the firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage. 6. No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise.
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7. Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it is practically impossible to determine the precise debt/equity ratio that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes
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