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Mini Case:
16  16
This example illustrates that financial leverage can increase the expected return to
stockholders.
But, at the same time, it increases their risk.
•
Firm L has a wider range of ROEs and a higher standard deviation of ROE,
indicating that its higher expected return is accompanied by higher risk.
To be
precise:
σ
ROE (Unleveraged)
= 2.12%, and
σ
ROE (Leveraged)
= 4.24%.
Thus, in a standalone risk sense, firm L is twice as risky as firm Uits business
risk is 2.12 percent, but its standalone risk is 4.24 percent, so its financial risk is
4.24%  2.12% = 2.12%.
f.
What does capital structure theory attempt to do?
What lessons can be learned
from capital structure theory?
Be sure to address the MM models.
Answer:
MM theory begins with the assumption of zero taxes.
MM prove, under a very
restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:
V
L
= V
U
.
Therefore, capital structure is irrelevant. Any increase in roe resulting from financial
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 Spring '08
 Staff
 Leverage

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