fm17 1 - Chapter 17 Capital Structure Decisions: Extensions...

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Answers and Solutions: 17 - 1 Chapter 17 Capital Structure Decisions: Extensions ANSWERS TO END-OF-CHAPTER QUESTIONS 17-1 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 zero-tax case, and the increasing use of lower cost debt causes the firm’s cost
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