QUESTION

(a) Based on MM's model with corporate taxes, explain what would happen to a company's debt ratio, firm value and WACC if the company decreased its use of debt relative to equity.

(b) Now assume the company in part (a) has a high level of business risk and its assets are mostly intangible. What assumption in MM's model with corporate taxes,if relaxed, may lead to the opposite effect (compared with part (a)) on firm value with increased use of debt? Name the theory that examines the effect of relaxing the assumption and explain how, in this case, it may lead to the opposite effect on firm value.

(c) Based on two of the factors that should be considered in determining optimal capital structure, explain why the optimal capital structure for a biotechnology company is likely to have a much lower proportion of debt than the optimal capital structure for a company running a chain of supermarkets.