Traditional View a As the level of leverage increase the cost of debt remains

Traditional view a as the level of leverage increase

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Traditional View a) As the level of leverage increase, the cost of debt remains unchanged up to a certain level. Beyond this level the cost of debt will increase b) The cost of equity rises as the level of leverage increases and financial risk increases. There is a non-linear relationship between the cost of equity and leverage c) The WACC does not remain constant falls initially as the proportion of debt capital increases Then begins to increase as the rising cost of equity becomes significant
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Traditional View d) The optimum level of leverage is where the company WACC is minimized.
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Modigliani-Miller (MM) View Assumptions of MM view b) A perfect capital market exists in which investors have the same information Upon which they act rationally To arrive to the same expectations about future earnings and risks c) There are no taxes or transaction costs d) Debt is risk-free and freely available at the same cost to investors and companies alike.
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Modigliani-Miller (MM) View In 1958 Modigliani and Miller proposed MM Proposition I The total market value of a company, in the absence of tax will be determined by two factors 3. Total earnings of the company 4. The level of operating risk attached to those earnings (The total market value would be computed by discounting the total earnings at a rate that is appropriate to the level of operating risk. The WACC) Thus the capital structure has no effect on the
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Modigliani-Miller (MM) view MM justified their approach by the use of arbitrage. MM Proposition II 3. The cost of debt remains unchanged as the level of leverage increases 4. The cost of equity rises in such a way as to keep the WACC constant.
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Graphical MM view The MM view would be represented on a graph as shown below
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Modigliani-Miller (MM) view Summing up MM view:
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