A friend argues that, even when the assumptions behind the Modigliani and Miller (M&M) Theorems hold...
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A friend argues that, even when the assumptions behind the Modigliani and Miller (M&M) Theorems hold (e.g., no taxes), the cost of assets (ra) goes up when a firm increases the fraction of debt in its capital structure. The argument he proposes is the following: i) ii) The cost of assets is a weighted average of the expected return on debt and the E D expected return on equity (₁ TE + =rd). E + D E + D As the firm increases the fraction of debt in its capital structure, the expected return on debt (ro) may increase and the expected return on equity (re) increases. As a result, the cost of assets increases, since plugging a higher rp and re in the equation above leads to a higher cost of assets. = Is your friend correct? If not, indicate where his logic breaks down (at i, ii or iii) and explain why. A friend argues that, even when the assumptions behind the Modigliani and Miller (M&M) Theorems hold (e.g., no taxes), the cost of assets (ra) goes up when a firm increases the fraction of debt in its capital structure. The argument he proposes is the following: i) ii) The cost of assets is a weighted average of the expected return on debt and the E D expected return on equity (₁ TE + =rd). E + D E + D As the firm increases the fraction of debt in its capital structure, the expected return on debt (ro) may increase and the expected return on equity (re) increases. As a result, the cost of assets increases, since plugging a higher rp and re in the equation above leads to a higher cost of assets. = Is your friend correct? If not, indicate where his logic breaks down (at i, ii or iii) and explain why.
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The ModiglianiMiller Theorem states that a firms cost of capital and i... View the full answer
Related Book For
Fundamentals of Financial Management
ISBN: 978-0324664553
Concise 6th Edition
Authors: Eugene F. Brigham, Joel F. Houston
Posted Date:
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