Question

True/False: In the context of perfect capital markets, suppose a firm increases the proportion of debt in its capital structure, but leaves all other aspects of its business unchanged.

Taken together, the Modigliani-Miller Propositions tell us that the firm’s increased reliance on the relatively cheap debt financing is perfectly offset by a rise in the required return paid to shareholders (as well as a potential rise in the required return paid to debt holders), such that the value of the firm is unchanged.

True/False: In the context of perfect capital markets, when a firm decreases the proportion of debt in its capital structure, the expected return on its equity falls.

True/False: In the context of perfect capital markets, when a firm increases the proportion of debt in its capital structure, the expected return on equity increases since the return on debt is lower than the firm’s return on assets.

Answer 1

1. True

Justification :-

As per Modigliani-Miller Proposition I, In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Further, the key idea behind that model is leverage (use of debt as well as equity to finance firm) affects who gets the firm’s cash flows but not the cash flows themselves. Therefore, change of debt composition does not effect the entreprise value but it might effect the cash flows in the hands of person receiving.

2. False

Justification:-

When firm use debt to provide addition capital for their business operations, equity owners get to keep any extra profits generated by the debt capital, after any interest payments. Given the same amount of equity investments, equity investors have a higher return on equity because of the additional profits provided by the debt capital. But, where as in opposite situation like where the debt proportion decreases it make burden on the investors to introduce the additional investment and it leads to reduce in the cost of equity due to sharing of income among all the existing and increased investors.

With perfect capital markets, the choice of debt or equity financing will not affect the total value of a firm, its share price, or its cost of capital. As a result, firms and their stockholders are indifferent to choice of financing.

Therefore, the given statment is False.

3. True

Justification:-

As per MM Proposition II, A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).

where:

is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium.

is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0).

is the required rate of return on borrowings, or cost of debt.

is the debt-to-equity ratio.

is the tax rate.

Further MM approach assumes the perfect capital markets, therefore the given statement is True.