I have a quick question about schweser’s answer, but first I’ll give a minute or 2 if anyone wants to just read and take a stab here: John Harrison is discussing the implications for Modigliani and Miller (MM’s) propositions (assuming no corporate or personal taxes) for manager’s decisions regarding capital structure with his supervisor, Harriet Perry. In the conversation, Harrison makes the following statements: Statement 1: According to MM’s propositions, increasing the use of cheaper debt financing will increase the cost of equity and the net change to the company’s weighted average cost of capital (WACC) will be zero. Statement 2: Since MM’s propositions assume that there are no taxes, equity is the preferred method of financing. What is the most appropriate response to Harrison’s statements? Statement 1 Statement 2 A) Agree Agree B) Disagree Disagree C) Disagree Agree D) Agree Disagree
D
I’ll go with D. There is still bankruptcy risk in the scenario given. Increase in debt will increase risk to equity holders. They will demand a higher return and the net change will be zero. Since there are no taxes you should be indifferent because there is no tax shield associated with debt in this scenario.
I say B.
Edit: I am still going with D but my reasoning for the second statement may be off. To be indifferent I think there must be no bankruptcy as well.
Your answer: B was incorrect. The correct answer was D) Agree Disagree Perry should agree with the first statement. MM asserts that the use of debt financing, although it is cheaper than equity, will increase in the cost of equity, resulting in a zero net change in the WACC. Perry should disagree with the second statement. Although MM’s propositions assume that there are no taxes, the conclusion is that the mix of debt and equity financing is irrelevant and that there is no preferred method of financing. So here’s my Q- the 2nd one is clearly wrong. the 1st one- agree that debt financing is going to up the cost of equity, but how do we know that the change in the WACC will be exactly 0? I thank anyone in advance for explaining this probably simple concept that i’m missing.
Hi banni…nice to see you posting again. The basic idea is this…In a no tax world companies should be indifferent to their capital structure. So it wouldn’t matter if the company was made up of 50/50 debt and equity or 70/30 debt equity. This is because operating earnings are avaliable to all providers of capital. So if the mix of capital doesn’t really matter how would WACC stay the same for a company that is 100/0 debt and equity vs a company that is 50/50 debt and equity (as we know that debt is always cheaper)? MM state that because debt holders have a priority claim on earnings from the firm that equity investors require a higher rate of return on their capital. In order for the above argument to hold, the cost of equity must increases linearly as the amount of debt used in the company increases (so WACC stays the same). This makes sense because the risk that the equity holder will never get paid goes up as the amount of debt in the capital structure increases. This all changes when taxes are throw into the mix.
thx for typing that out. makes sense. with that, i’m calling it a night. yes i will be back here tomorrow night. it’s may, i officially have given up my life for the CFA.
Welcome to the club.