Unformatted text preview: ntitled to) to the value of equity increases. Thus,
as leverage increases, the ratio of the market value of the equity to income after
interest decreases. b. (i) Assume MM are correct. The market value of the firm is determined by the
income of the firm, not how it is divided among the firm’s security holders. Also, the firm’s income before interest is independent of the firm’s financing. Thus, both the value of the firm and the value of the firm’s income before
interest remain constant as leverage is increased. Hence, the ratio is a
constant. (ii) Assume the traditionalists are correct. The firm’s income before interest is
independent of leverage. As leverage increases, the firm’s cost of capital
first decreases and then increases; as a result, the market value of the firm
first increases and then decreases. Thus, the ratio of the market value of the
firm to firm income before interest first increases and then decreases, as leverage increases.
11. We begin with rE and the capital ass...
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