Question

In: Finance

According to the Modigliani Miller approach, how does using debt affect the business value?

  1. According to the Modigliani Miller approach, how does using debt affect the business value?

Solutions

Expert Solution

Answer

The Modigliani – Miller is identical with the Net Operating Income Approach. Modigliani and
Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not affected
by the changes in capital structure. In other words, capital structure decisions are irrelevant and value
of the firm is independent of debt – equity mix.

Explanation of how using the debt affect the business

Many business organization like to operate the business as debt free But a reasonable amount of debt can provide some financial benefits.Debt is cheaper than equity and the debt's interest payments are tax deductable.So, as the level of debt increases, returns to equity owners also increase enhancing the company’s value.

If debt risk is not a factor then the more debt a business has, the greater its value would be. But at a certain level of debt, the risks associated with higher leverage begin to outweigh the financial advantages.When debt reaches this point, investors may expect higher returns as compensation for taking on greater risk, which has a negative impact on business value.


Related Solutions

Modigliani-Miller argue that except for taxes, debt would have no impact on ‘firm’ value. What is...
Modigliani-Miller argue that except for taxes, debt would have no impact on ‘firm’ value. What is the basis of this argument? Why does it break down in reality?
debt to equity ratio: How does a business value on the number scale overall affect a...
debt to equity ratio: How does a business value on the number scale overall affect a business financial well-beng?
A- Discuss the traditional theory relating to capital structure and the approach by Modigliani and Miller
A- Discuss the traditional theory relating to capital structure and the approach by Modigliani and Miller
According to Modigliani and Miller and the dividend irrelevance argument which of the following statements is...
According to Modigliani and Miller and the dividend irrelevance argument which of the following statements is true? a. Only firms with temporary excess cash should pay a dividend. b. Regardless of the tax treatment of dividends, investors prefer dividends since they receive cash today as opposed to postponing receiving capital gains. c. Firms pay the same total return (dividends and price appreciation combined) so without tax differences investors should be indifferent to receiving their returns as dividends of price appreciation....
Modigliani and Miller argued that the value of a firm is separate from the source of...
Modigliani and Miller argued that the value of a firm is separate from the source of financing for its assets. Do you agree? Why or why not? Do you believe that, for any or all firms, there exists an optimal capital structure? Why or why not? How do taxes impact their original findings? If tax laws changes eliminated the deductibility of interest for corporations, would this motivate or deter corporations from increasing the level of debt in their capital structure?...
According to Modigliani-Miller propositions, a firm’s cost of equity in a perfect financial market is determined...
According to Modigliani-Miller propositions, a firm’s cost of equity in a perfect financial market is determined by all of the followings EXCEPT ____. Group of answer choices A. risk-free interest rate B. reward to the total business risk C. reward to the nondiversifiable portion of the business risk D. reward to additional risk added by financial leverage
8. List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected...
8. List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure?
Modigliani and miller demonstrated that "capital structure does not matter" in a perfect capital market. However,...
Modigliani and miller demonstrated that "capital structure does not matter" in a perfect capital market. However, this statement is at odds due to market imperfections. Explain how market imperfections reshape firm's choice of capital structure.
Assume a Modigliani-Miller world. Genron Corporation has $20 million in excess cash and has no debt....
Assume a Modigliani-Miller world. Genron Corporation has $20 million in excess cash and has no debt. The firm expects to generate additional free cash flow of $48 million per year. It has 10 million shares outstanding. Genron decides to use the $20 million excess cash to repurchase shares on the open market. After the share repurchase, Genron plans to distribute its annual free cash flow as dividends. Genron’s cost of capital is 12%. Show that Genron’s share price does not...
Using the Modigliani-Miller (MM) theory in a perfect market, you want to evaluate a project and...
Using the Modigliani-Miller (MM) theory in a perfect market, you want to evaluate a project and how to finance it. The project has free cash flows in one year (year 1) of $90 in a weak economy or $120 in a strong economy. There is 75% chance that the economy is strong.  The initial investment required for the project is $80, and the project's cost of capital is 10%.  The risk free interest rate is 5%. Suppose that to raise the funds...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT