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Answers and Solutions:
17  1
Chapter 17
Capital Structure Decisions: Extensions
ANSWERS TO ENDOFCHAPTER QUESTIONS
171
a. MM Proposition I states the relationship between leverage and firm value.
Proposition I without taxes is V = EBIT/r
sU
.
Since both EBIT and r
sU
are constant,
firm value is also constant and capital structure is irrelevant.
With corporate taxes,
Proposition I becomes V = V
u
+ TD. Thus, firm value increases with leverage and the
optimal capital structure is virtually all debt.
b. MM Proposition II states the relationship between leverage and the cost of equity.
Without taxes, Proposition II is r
sL
= r
sU
+ (r
sU
– r
d
)(D/S).
Thus, r
s
increases in a
precise way as leverage increases.
In fact, this increase is just sufficient to offset the
increased use of lower cost debt.
When corporate taxes are added, Proposition II
becomes r
sL
= r
sU
+ (r
sU
– r
d
)(1 – T)(D/S).
Here the increase in equity costs is less
than the zerotax case, and the increasing use of lower cost debt causes the firm’s cost
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 Spring '08
 Staff
 Leverage

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