Debt Policy

Question 1

Financial Leverage

Answer 1

Finance of investment partly or wholly by debt

Question 2

Modigliani-Miller proposition 1

Answer 2

The market value of any firm is independent of its capital structure

Firm value is determined by real assets and not by the proportions of debt and equity securities issued to buy assets

Question 3

Modigliani-Miller assumptions

Answer 3

• Competitive markets
• Efficient markets
• Absence of taxation
• Absence of bankruptcy costs
• Investment opportunities unaffected by financing decisions

Question 4

Modigliani-Miller proposition 2

Answer 4

The expected rate of return on the common stock level of a levered firm increases in proportion to the market value of the debt-equity ratio (D/E).

The rate of increase depends on the spread between the expected return on all firm’s securities/assets and the return on debt

Question 5

Modigliani-Miller implications

2 implications

Answer 5

IMPLICATION 1
- Financial leverage has no effect on shareholders wealth

IMPLICATION 2
- The rate of return the firm can expect to receive on their shares increases as the firm’s debt-equity ratio increases

Question 6

Tax deduction

Tax shield equation

Answer 6

Tax shield = Interest payment x Corporate Tax Rate