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Questions and Answers
What happens to the cost of equity as a firm increases its debt level?
What happens to the cost of equity as a firm increases its debt level?
What is the outcome on overall cost of capital when a firm changes its leverage?
What is the outcome on overall cost of capital when a firm changes its leverage?
Which industry is likely to have companies with high debt-equity ratios?
Which industry is likely to have companies with high debt-equity ratios?
In the context of MM Proposition II without corporate taxes, what effect does debt have on firm value?
In the context of MM Proposition II without corporate taxes, what effect does debt have on firm value?
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What does MM suggest about corporate managers' treatment of capital structure decisions?
What does MM suggest about corporate managers' treatment of capital structure decisions?
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What is the share of funds needed to invest in the levered firm's debt if x is given as 0.4?
What is the share of funds needed to invest in the levered firm's debt if x is given as 0.4?
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If the total investment is $1,500, how much will be invested in the levered firm's equity?
If the total investment is $1,500, how much will be invested in the levered firm's equity?
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What will be the debt-to-equity ratio of the levered firm with a debt investment of $600 and equity investment of $900?
What will be the debt-to-equity ratio of the levered firm with a debt investment of $600 and equity investment of $900?
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According to the Modigliani-Miller Proposition I, how is firm value affected by leverage?
According to the Modigliani-Miller Proposition I, how is firm value affected by leverage?
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What is one of the key assumptions of the Modigliani-Miller theorem?
What is one of the key assumptions of the Modigliani-Miller theorem?
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If individuals can only borrow at a higher rate than corporations, what happens to firm value?
If individuals can only borrow at a higher rate than corporations, what happens to firm value?
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What does homemade leverage suggest about capital structure?
What does homemade leverage suggest about capital structure?
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What remains constant for a given firm and is unaffected by leverage?
What remains constant for a given firm and is unaffected by leverage?
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What is one assumption of the Modigliani-Miller model regarding capital markets?
What is one assumption of the Modigliani-Miller model regarding capital markets?
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In the example provided, what is the interest rate on the borrowed funds to purchase shares?
In the example provided, what is the interest rate on the borrowed funds to purchase shares?
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What does 'homemade leverage' refer to in the context of this content?
What does 'homemade leverage' refer to in the context of this content?
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What is the ROE (Return on Equity) for the levered firm's earnings during expected recession?
What is the ROE (Return on Equity) for the levered firm's earnings during expected recession?
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To replicate the EPS of the unlevered firm, what action must an investor take regarding their portfolio?
To replicate the EPS of the unlevered firm, what action must an investor take regarding their portfolio?
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What are firms unable to do concerning firm value, based on the initial premise of the content?
What are firms unable to do concerning firm value, based on the initial premise of the content?
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When borrowing $1,000 to invest in shares at $50 each, how many shares does the investor purchase?
When borrowing $1,000 to invest in shares at $50 each, how many shares does the investor purchase?
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What is the Debt/Equity ratio in the proposed capital structure?
What is the Debt/Equity ratio in the proposed capital structure?
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What is the expected EPS under the proposed capital structure during expansion?
What is the expected EPS under the proposed capital structure during expansion?
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How does the ROE change from the current to the proposed capital structure during a recession?
How does the ROE change from the current to the proposed capital structure during a recession?
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What is the net income in the proposed capital structure during expected performance?
What is the net income in the proposed capital structure during expected performance?
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What is the effect of introducing debt on EPS when comparing current and proposed capital structures during recession?
What is the effect of introducing debt on EPS when comparing current and proposed capital structures during recession?
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What is the primary conclusion of Modigliani and Miller regarding capital structure and firm value?
What is the primary conclusion of Modigliani and Miller regarding capital structure and firm value?
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What is the interest expense deducted from EBIT in the proposed capital structure?
What is the interest expense deducted from EBIT in the proposed capital structure?
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What is the return on assets (ROA) during an expansion in both capital structures?
What is the return on assets (ROA) during an expansion in both capital structures?
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In the current capital structure, what is the total equity reported?
In the current capital structure, what is the total equity reported?
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What does an increase in leverage generally do to the risk and return for stockholders?
What does an increase in leverage generally do to the risk and return for stockholders?
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What is the formula for calculating the WACC of an unlevered firm?
What is the formula for calculating the WACC of an unlevered firm?
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In the context of Proposition II, what does rs represent?
In the context of Proposition II, what does rs represent?
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If a firm has a debt value (B) of $8,000 and a levered equity (SL) of $12,000, what is the debt-to-equity ratio used in Proposition II?
If a firm has a debt value (B) of $8,000 and a levered equity (SL) of $12,000, what is the debt-to-equity ratio used in Proposition II?
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What remains constant when a firm leverages its capital structure according to the Modigliani-Miller Proposition II?
What remains constant when a firm leverages its capital structure according to the Modigliani-Miller Proposition II?
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Given rB is 0.08 and r0 is 0.1, what will be the return on equity (rs) if B is $10,000 and SL is $30,000?
Given rB is 0.08 and r0 is 0.1, what will be the return on equity (rs) if B is $10,000 and SL is $30,000?
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What is the expected earnings after interest for a levered firm with an equity value of $12,000?
What is the expected earnings after interest for a levered firm with an equity value of $12,000?
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Which of the following statements is true regarding the relationship between debt and unlevered equity?
Which of the following statements is true regarding the relationship between debt and unlevered equity?
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What does Proposition I state about firm value and leverage?
What does Proposition I state about firm value and leverage?
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In the equation for return on equity given in Proposition II, what does 'TC' represent?
In the equation for return on equity given in Proposition II, what does 'TC' represent?
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How is the return on equity calculated with corporate taxes, based on Proposition II?
How is the return on equity calculated with corporate taxes, based on Proposition II?
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What effect does financial leverage have on the cost of equity capital?
What effect does financial leverage have on the cost of equity capital?
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What is the primary benefit of leveraging a firm in terms of taxes?
What is the primary benefit of leveraging a firm in terms of taxes?
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In the cash flow example provided, how does total cash flow to shareholders in the expected scenario for a levered firm compare to an all-equity firm?
In the cash flow example provided, how does total cash flow to shareholders in the expected scenario for a levered firm compare to an all-equity firm?
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Which of the following accurately describes 'rWACC' based on the financial equations provided?
Which of the following accurately describes 'rWACC' based on the financial equations provided?
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What happens to the value of debt in relation to equity when considering the benefits of the interest tax shield?
What happens to the value of debt in relation to equity when considering the benefits of the interest tax shield?
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What is the formula for the weighted average cost of capital (WACC) mentioned in the content?
What is the formula for the weighted average cost of capital (WACC) mentioned in the content?
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Study Notes
Capital Structure and Firm Value
- Firm value equals the sum of debt and equity values (V = B + S).
- Management aims to maximize firm value.
- The optimal debt-equity ratio maximizes the pie (firm value).
Capital Structure Question
- Stockholders prioritize firm value maximization, not just equity maximization.
- Finding the debt-equity ratio that maximizes shareholder value is crucial.
Maximizing Firm Value Versus Maximizing Stockholder Interests
- Shareholders should care about maximizing firm value, not just equity.
- Changes in capital structure impact shareholders only if firm value changes.
- Managers should choose the capital structure that maximizes firm value.
- The "optimal" mix of debt and equity maximizes firm value.
Financial Leverage, EPS, and ROE
- A firm considering debt from an all-equity structure is possible.
- This example demonstrates the impact of debt on financial ratios like EPS and ROE under different economic scenarios (recession, expected, and expansion).
EPS and ROE - All Equity Firm
- This section presents EPS and ROE calculations under different economic scenarios (recession, expected, and expansion) using an all equity firm structure.
EPS and ROE Under Proposed Capital Structure
- This section shows calculations for EPS and ROE under the same scenarios using a proposed capital structure with debt involved, highlighting financial leverage's impact.
EPS and ROE Under Both Capital Structures
- This section provides a comparison table showing EPS and ROE under the all-equity and proposed leveraged scenarios across different economic outlook including recession, expected, and expansion cases
Financial Leverage and EPS
- Graph illustrating the relationship between EBIT and EPS in various capital structures (levered/unlevered). Key points are identified like break-even point, advantage/disadvantage to debt.
Leverage and Firm Value
- Modigliani and Miller proposition: In the absence of taxes and perfect capital markets, capital structure is irrelevant to firm value.
- Managers can't boost value by changing the mix of financing instruments.
Assumptions of the Modigliani-Miller Model
- Key assumptions underlying the Modigliani-Miller model include homogeneous expectations, homogenous risk classes, perpetual cash flows, perfect capital markets (perfect competition, equal access to information, no transaction costs, no taxes), and no transaction costs.
Homemade Leverage Example
- Demonstrating the creation of leverage using a personal portfolio to replicate a levered firm's effects without actually having to change your financial situation
Homemade Leverage: An Example
- An example illustrating how a personal portfolio can duplicate a levered firm's EPS and ROE.
Homemade (Un)Leverage Example
- Demonstrating the reverse process of replicating unlevered firm positions using a leveraged firm's debt and equity holdings.
Homemade (Un)Leverage: Example
- This section determines the proportion of investment in debt and equity (for a levered firm). to replicate an unlevered firm's characteristics.
Homemade (Un)Leverage: An Example
- Shows a personal replication of the unlevered firm characteristics using the levered firm structure.
MM Proposition I (No Taxes)
- Firm value is independent of capital structure. Implying that capital structure choices don't affect the firm's total value in perfect capital markets with no taxes. Formula VL = VU.
Key Assumptions
- The Modigliani-Miller (M&M) proposition relies on assumptions like zero taxes and equal access to borrowing opportunities for firms and individuals.
Implications of Proposition I
- WACC isn't affected by leverage within the no tax scenario.
Implications of Proposition II (No Taxes)
- Leverage affects the cost of equity according to Proposition II. (Formula presented).
MM Proposition II with No Corporate Taxes
- Cost of equity is a linear function of debt-equity ratio.
MM Interpretation – No Taxes
- As leverage increases, the cost of equity increases because of higher risk but increase in the overall cost of capital is canceled by low cost debt financing
MM in Practice
- Real-world firm leverage often differs significantly from the capital structure theory.
Taxes: The MM Propositions I & II (With Taxes)
- Firm value increases with leverage when there are corporate taxes (VL > VU) and this increase is due to offsetting the effect of taxes via the tax shield. (Formula for VL presented)
- Some of the equity risk and return is offset by interest tax shields (Formula for rs presented).
The Effect of Financial Leverage on the Cost of Debt and Equity Capital With Corporate Taxes
- Graph illustrating cost of capital changes, considering leverage. This also explains how the cost of capital does not change for the levered and unlevered firm, since the tax shield offset is equal to the additional cost of equity.
Total Cash Flow to Investors Under Each Capital Structure With Corporate Taxes
- This section compares the total cash flows to investors under both the all-equity and levered firm setups across different economic scenarios.
Total Cash Flow to Investors Under Each Capital Structure
- This demonstrates how the cash flow to investors is impacted by capital structure in the presence of Corporate Taxes.
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Description
This quiz covers essential concepts related to capital structure, including the relationship between firm value, debt, and equity. It emphasizes the importance of maximizing firm value over just equity for shareholders. Understanding the optimal debt-equity ratio is key for enhancing firm value.
