Lecture 9: 17. Capital Structure Theory - Does Debt Policy Matter?

Question 1

MM proposition 1

Answer 1

Value of a firm stays the same regardless of changes to capital structure. Financial leverage has no impact on shareholder’s wealth

Question 2

MM proposition 2

Answer 2

Return on equity increases in proportion to DE Ratio.
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.

Question 3

MM assumptions

Answer 3

1. Perfect world, no taxes/transaction costs

2. Infinite number of replaceable firms,

Question 4

traditionalists critique MM arguing that

Answer 4

market imperfections make personal borrowing excessively risky, and inconvenient for some investors, creating a natural clientele who pay a premium for shares of levered firms. They argue that firms should borrow to realise the premium