Lent Term - Lecture 1

Question 1

What is the Modigliani - Miller Theorem?

Answer 1

in a frictionless economy the value of a firm does not depend on its capital structure

Question 2

What happens to a firm’s equity cost of capital as the leverage increases?

Answer 2

It increases as debt makes equity more risky

Question 3

What assumptions are necessary for there to be no optimal capital structure according to M&M?

Answer 3

1) Competitive & complete markets
2) Individuals and firms can undertake financial transactions at the same prices
3) No taxes, bankruptcy or other transaction costs
4) Financing decision neither affects cash flows generated by assets nor conveys information

Question 4

What is M&M Proposition I?

Answer 4

In a frictionless economy total firm value is independent of capital structure

Question 5

What is M&M Proposition II?

Answer 5

A firms cost of equity capital increases as the market value debt to equity ratio increases. However, the overall cost of capital remains constant.

Question 6

What happens to a firm’s overall cost of capital as leverage increases?

Answer 6

Nothing, it stays constant

Question 7

What is the irrelevance opposition?

Answer 7

basically the reason why rd is unaffected by D//E if D is small

Question 8

Why are dividends irrelevant in an M%M world?

Answer 8

Because if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the value of the firm.
Still, dividends are relevant to figure out the value of one share.