. This is two shots in one question. Please attempt to answer all correctly. Tha

Question

.

This is two shots in one question. Please attempt to answer all correctly. Thanks

6. Assumptions of the Modigliani and Miller proposition Aa Aa Modern capital structure theory, constructed by Modigliani and Miller, began in 1958 and provided justifications for increasing leverage under certain assumptionsCEOs and CFOs were encouraged to adopt this theory into practice, especially when spending is high and the risk of servicing debt is low. As capital markets have evolved, it is critical to understand the context and assumptions under which this model was created. Review the situation and answer the questions that follow: An analyst has graphed the relationship between the expected return on a firm's capital and its debt-equity (D/E) ratio. Her graph follows: RATES OF RETURN (Percent] 20 18 16 14 12 10 Equity rAssets Debt 00 0.51.0 1.5 DEBT-EQUITY D/E RATIO 2.0 From what you see on the graph, which of the following assumptions is consistent with the graph?

Explanation / Answer

1)

change in debt equity ratio has an effect on WACC (Weighted Average Cost of Capital). This means higher the debt, lower is the WACC.

Therefore, option a is correct.

2)

Modigliani and Miller Approach indicates that value of a leveraged firm (firm which has a mix of debt and equity) is the same as the value of an unleveraged firm (firm which is wholly financed by equity)

Therefore

Value of levered = Value of unlevered

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