Traditional Viewa)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 increaseb)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 leveragec)The WACC does not remain constant falls initially as the proportion of debt capital increasesThen begins to increase as the rising cost of equity becomes significant
Traditional Viewd)The optimum level of leverage is where the company WACC is minimized.
Modigliani-Miller (MM) ViewAssumptions of MM viewb)A perfect capital market exists in which investors have the same informationUpon which they act rationallyTo arrive to the same expectations about future earnings and risksc)There are no taxes or transaction costsd)Debt is risk-free and freely available at the same cost to investors and companies alike.
Modigliani-Miller (MM) ViewIn 1958 Modigliani and Miller proposed MM Proposition IThe total market value of a company, in the absence of tax will be determined by two factors3.Total earnings of the company4.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
Modigliani-Miller (MM) viewMM justified their approach by the use of arbitrage.MM Proposition II3.The cost of debt remains unchanged as the level of leverage increases4.The cost of equity rises in such a way as to keep the WACC constant.
Graphical MM viewThe MM view would be represented on a graph as shown below