16.30. Compute a graph similar to Exhibit 16.2. Use a spreadsheet. Your firm wil

Question

16.30. Compute a graph similar to Exhibit 16.2. Use a spreadsheet. Your firm will be worth either $50,000 or $100,000 with equal probabilities. The cost of capital on your debt is given by the formula 8( rDebt) = 5% + 10% • co Debt-but only if the debt is risky. (Hint: The risk-free rate of return is 11.85%. What is the WACC of the firm if it is 100% debt fi-nanced?

Exhibit 16.2 below:

Capital Structure in a Perfect Binomial Payoffs (as in the text) 140 e 120 120 100 100 Equity, Expected 2 80 60 40 20 0 WACC Bond, Promised Bond, Expected 80 100 60 0 20 40 Debt Ratio, in % Normally Distributed Payoffs 100 80 E 60 6 40 Equity, Expected WACC 20 Bond, Expected 20 40 60 80 100 Debt Ratio, in % Exhibit 16.2: The Cost of Capital in a Pe ect World. The top graph illustrates the binomial example worke in the table in the text. Until the debt ratio reaches around 80% of the firm value, the debt is risk-free. Ho more debt still increases the risk of equity, and therefore its expected rate of return. For debt ratios highe 80%, the debt is risky and has to offer a higher promised and expected rate of return. The lower grap a similar figure for a firm that has normally distributed payoffs. In both cases, the WACC is always th regardless of the mix of debt and equity

Explanation / Answer

Ans;

The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this simplified view, the weighted average cost of capital (WACC) should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC. Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs

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