Question 3 (15 marks)

Capital Structure Policy

Part A. Imagine a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to:

(a) The ratio of the market value of the equity to income after interest if M&M propositions are right?

(b) The ratio of the market value of the firm to income before interest if M&M propositions are right?

Part B. Each of the following statements is false or at least misleading. Use M&M propositions to explain why in each case.

(a) As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.

(b) Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders.

(c) The more debt the firm issues, the higher the interest rate it must pay. That is one important reason why firms should operate at conservative debt levels.