fm17 3 - eL and a larger WACC So the MM model will...

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Answers and Solutions: 17 - 3 17-3 MM without taxes would support AT&T, although if AT&T really believed MM, they should not object to Gordon’s 50 percent debt ratio. MM with taxes would lead ultimately to 100 percent debt, which neither Gordon nor AT&T accepted. In effect, Gordon and AT&T seemed to be taking a “traditional” or perhaps a “compromise” view, but with different conclusions about the optimal debt ratio. We might note, in a postscript, that AT&T did raise its debt ratio, but not to the extent that Gordon recommended. 17-4 The value of a growing tax shield is greater than the value of a constant tax shield. This means that for a given initial level of debt a growing firm will have more value from the debt tax shield than a non-growing firm. Thus for a given face value of debt, D, and unlevered value of equity, U, a growing firm will have a smaller w D , a larger levered cost of equity, r
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Unformatted text preview: eL , and a larger WACC. So the MM model will underestimate the value of the levered firm and its cost of equity and WACC. 17-5 If equity is viewed as an option on the total value of the firm with a strike price equal to the face value of debt then the equity value should be affected by risk in the same way that an option is affected by risk. An option is worth more if the underlying asset is more risky, so a manager wanting to maximize the option value of the firm might want to switch investment decisions to make the firm more risky. Of course bondholders will not like this, since the increase in equity value comes at their expense. They will write covenants in to the bonds specifying how the proceeds can be used, and if management still manages to engage in this “bait and switch” tactic, the firm will find it difficult to raise capital through bond issues in the future....
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