Question

1. Under the M&M world with perfect capital markets, the cost of equity is independent of its capital structure.

   True

   False

2. Under the M&M world with perfect capital markets, a firm’s value should rise with increased leverage because debt is cheaper than equity.

   True

   False

3. Under the M&M world with perfect capital markets, a firm’s average cost of capital (i.e. pre-tax WACC) falls for increases in debt as long as the firm avoids truly excessive leverage.

   True

   False

Answer 1

Under the MM approach in a world with perfect capital markets, there is an assumption that there are no taxes, no transaction cost.

In such a world:

The value of the company will remain the same.

This is only a change in the capital structure of the company.

The amount of debt issued will be used today repurchase stocks, Thus reducing equity.

(As there are no taxes, there is no tax benefit for the issue of debt).

The overall weighted average cost of capital of the company will always be equal to the unlevered cost of equity.

Thus WACC remains constant.

There is only a change in the cost of equity- it is based upon the capital structure of the company.

WACC = weight of equity x cost of equity+ weight of debt X cost of debt.

1. FALSE.
The overall weighted average cost of capital of the company will always be equal to the unlevered cost of equity.

Thus WACC remains constant.

There is only a change in the cost of equity- it is based upon the capital structure of the company.

2. FALSE.
The value of the company will remain the same.

This is only a change in the capital structure of the company.

The amount of debt issued will be used today repurchase stocks, Thus reducing equity.

3. FALSE.
Thus WACC remains constant.

WACC = weight of equity x cost of equity+ weight of debt X cost of debt.