Assumptions of the Modigliani and Miller proposition Modern capital structure theory, constructed by Modigliani and Miller,...

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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 M&M'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: RATES OF RETURN (Percent) 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: 20 18 16 14 12 10 8 6 4 0 0.0 0.5 1.0 1.5 Equity Assets 2.0 DEBT-EQUITY D/E RATIO "Debt. Aa Aa From what you see on the graph, which of the following assumptions is consistent with the graph? O The firm's debt has default risk. O The firm's debt is risk free. O The firm's expected return on assets depends on its financial leverage. O Excessive financial leverage causes debt to become more risky than equity. Based on the assumption that a firm operates in a tax-free world, Modigliani and Miller made an important proposition about the value of a levered portfolio or company (VL) and an unlevered portfolio or firm (Vu). Which of the following equations best represents the conclusion from the MM: No Tax theory? OVU = SL - D VL SL = D Vu # VL VL = SL + D 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 M&M'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: RATES OF RETURN (Percent) 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: 20 18 16 14 12 10 8 6 4 0 0.0 0.5 1.0 1.5 Equity Assets 2.0 DEBT-EQUITY D/E RATIO "Debt. Aa Aa From what you see on the graph, which of the following assumptions is consistent with the graph? O The firm's debt has default risk. O The firm's debt is risk free. O The firm's expected return on assets depends on its financial leverage. O Excessive financial leverage causes debt to become more risky than equity. Based on the assumption that a firm operates in a tax-free world, Modigliani and Miller made an important proposition about the value of a levered portfolio or company (VL) and an unlevered portfolio or firm (Vu). Which of the following equations best represents the conclusion from the MM: No Tax theory? OVU = SL - D VL SL = D Vu # VL VL = SL + D

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