Debt policy

Question 1

MM Propostion 1

Answer 1

When there are no taxes and markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix of securities issued to finance the company.

Question 2

Mm proposition 1 assumptions

Answer 2

Well functioning and efficient markets:
Investors can trade securities without restrictions
Investors can borrow and lend at the same terms as the firm
Securities are fairly priced given the information available to investors

2. To taxes (no distortion)
3. No bankruptcy costs

Question 3

Mm prop formula 1

Answer 3

R equity = r assets + D/E (r assets - r debt)

Question 4

Mm propostion 2

Answer 4

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

Question 5

Summary

Answer 5

The choice of capital does not affect the value of the firm or its cost of capital

Capital structure should not mater for shareholders

Borrowing decreases or increases EPS depending on the level of revenues

Borrowing increases financial risk and consequently the cost of equity capital