Aa Aa 4. Assumptions of the Modigliani and Miller proposition Modern capital str

Question

Aa Aa 4. Assumptions of the Modigliani and Miller proposition Modern capital structure theory, constructed by Modigliani and Miller, began in 1958 and provided a justification for a corporation's use of more and more financial leverage under certain assumptions. CEOs and CFOs were encouraged to accept MBM's theory and put it into practice, especially when the company's spending is high and the risk of servicing its 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 IPercent 20 18 16 14 12 10 Equity Assets Deb 1.5 DEBT-EQUITY DVE RATIO 0.5 1.0 2.0

Explanation / Answer

Question - 1 ............ Option - 2

If Leverage increases, the cost of equity increases enough to keep the WACC constant.

In the given graph we can observe the raising curve for requity i.e upward sloping and WACC = rasset is flat.

Question - 2 ..................Option - 2 Vu = Vl

In the absence of there is not advantage from tax saving from interest. Hence value of the firm is dependent on EBIT and WACC. Both of these remain same for any D/E ratio.

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