The Modigliani and Miller Theory, sometimes referred to as the ‘MM Pie Theory’ or the ‘Pizza Analogy’, suggests that in a world without taxes, transaction costs, or financial distress costs, the capital structure should not influence the value of the firm.

REQUIRED:

Explain the logic and intuition behind the MM conclusion

List three assumptions underpinning the MM theory

Explain whether the three assumptions you have listed in (ii) above are reasonable in the real world.

QUESTION 4.2

Explain the relationship between firm value and the value of shareholders’ equity in a world without taxes, transaction costs, or financial distress costs.

QUESTION 4.3

Explain whether business risk and financial risk are the same things. For example, if firm A has more business risk than firm B, will it also have a higher cost of equity?

QUESTION 4.4

Company A and Company B are identical firms in all respects except for their capital structure. A is all equity financed with NKr600,000 in equity shares. B uses both shares and perpetual debt; its equity is worth NKr300,000, and the interest rate on its debt is 10%. Both firms expect EBIT to be NKr73,000. Ignore taxes.

Knut owns NKr30,000 worth of B’s shares. What rate of return is he expecting?

Show how Knut could generate exactly the same cash flows and rate of return by investing in A and using homemade leverage.

What is the cost of equity for A? What for B?

What is the WACC for A? For B? What principle have you illustrated?

QUESTION 4.5

Old School Corporation expects an EBIT of £9000 every year forever. Old School currently has no debt, and its cost of equity is 17%. The firm can borrow at 10%. What is the firm's value if the corporate tax rate is 28%? What will be the value if Old School converts to 50% debt? To 100% debt?

QUESTION 4.6

Williamsen GmbH has a debt-equity ratio of 2.5. The firm’s weighted average cost of capital is 15%, and its pre-tax cost of debt is 10%. Williamsen is subject to a corporate tax rate of 35%.

REQUIRED:

Calculate Williamsen’s cost of equity capital.

Calculate Williamsen’s unlevered cost of capital.

Calculate Williamsen’s weighted WACC if the firm’s debt-equity ratio is 0.75.

Calculate Williamsen’s WACC if its debt-to-equity ratio is 1.5.

QUESTION 4.7

The pre-tax cost of debt for Slim Balance Sheet plc is 5%, and the cost of equity is 9%. The relevant corporation tax rate is 20%. Marginal Personal tax rates are 45% on interest payments and 35% on dividend payments. Slim balance sheet is currently financed with £30,000,0000 of equity and £70,000,000 of debt. Earnings before interest and tax (EBIT) are £10,000,000. Assume that Slim pays out 100% of its distributable earnings as either dividends or interest.

REQUIRED:

Calculate the proportion of the company’s EBIT that shareholders receive after tax.

Calculate the proportion of the company’s EBIT that bondholders receive after tax.

If the corporation tax rate remained at 20%, and the dividend tax rate remained at 35%, calculate the personal tax rate on interest payments that would make the company indifferent between equity and debt financing.

Reflecting upon your answer to (iii) above, how can governments encourage companies to favour equity over debt financing, and why might they wish to do this?

QUESTION 4.8

Are there any EESG issues to consider when considering the optimal capital structure about tax? Explain your answer with reasoned arguments.

TUTORIAL PROBLEMS – WEEK 6

QUESTION 4.9

Identify examples of and explain both direct and indirect costs of financial distress.

QUESTION 4.10

Despite the high costs of high leverage, tax systems worldwide have an inbuilt debt bias. Why do you think this is?

QUESTION 4.11

Identify and explain how the costs of debt can be reduced.

QUESTION 4.12

With the aid of diagram(s), explain the relation between firm value and leverage, taking into account the effect of taxes and financial distress costs.

QUESTION 4.13

Explain with diagrams how the ‘Pie Model’ with real-world factors differs from the basic pie model.

QUESTION 4.14

Explain ‘Signalling Theory’.

QUESTION 4.15

Identify and explain the ‘Agency Costs of Equity.’

QUESTION 4.16

Explain what the ‘Pecking Order Theory’ means and how it relates to the observed capital structure of companies. If the pecking order theory holds, why do companies sometimes launch a deeply discounted rights issue?

QUESTION 4.17

Explain how growth affects the desired debt-to-equity ratio of a company. Explain the impact of growth opportunities in relation to the ‘Static Trade-off Theory and the ‘Pecking Order Theory’ of capital structure.

QUESTION 4.18

Explain whether the ‘Market Timing Theory’ of capital structure is consistent with the pecking order theory.

QUESTION 4.19

In all countries, it has been observed that some firms appear to have a target capital structure while others do not. Explain what this might mean regarding the validity of the trade-off theory, the pecking order theory and the market timing theory.

QUESTION 4.20

Explain whether there are there any EESG issues regarding the following corporate practices:

Firms using the threat of a bankruptcy filing to force creditors to renegotiate terms.

Firms filing for bankruptcy as a means of reducing labour costs

Firms maximising deb

Answer rating: 100% (QA)

ANSWER Question 41 Explain the logic and intuition behind the MM conclusion The Modigliani and Miller MM Theory also known as the MM Pie Theory or the Pizza Analogy argues that the capital structure o... View the full answer