fm16 16 - This example illustrates that financial leverage...

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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 stand-alone risk sense, firm L is twice as risky as firm U--its business risk is 2.12 percent, but its stand-alone 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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