Which of the following statements about capital structure theories is most accurate? A)In a world with taxes and bankruptcy costs one would expect there to be an optimal capital structure where the cost of capital is minimized and share price is maximized. B)In a Modigliani and Miller (MM) world with taxes, but no bankruptcy cost, you would expect to see firms taking on very little debt. C)Based on signaling theory, if a firm issues new common stock it means that the firm thinks future investment prospects are better than normal. D)In a perfect no tax world, MM would tell you that the firm’s weighted average cost of capital (WACC) is increasing and the firm’s capital structure will influence the firm’s stock price.
A.
L2candidate777 Wrote: ------------------------------------------------------- > Which of the following statements about capital > structure theories is most accurate? > > A)In a world with taxes and bankruptcy costs one > would expect there to be an optimal capital > structure where the cost of capital is minimized > and share price is maximized. > > B)In a Modigliani and Miller (MM) world with > taxes, but no bankruptcy cost, you would expect to > see firms taking on very little debt. With just taxes MM would say that you should lever up all the way to lower WACC due to the tax sheild. This raises bankruptcy probabilities, but they are ignoring them. > > C)Based on signaling theory, if a firm issues new > common stock it means that the firm thinks future > investment prospects are better than normal. If a company issues more debt it is seen as a positve since they are saying they can handle the additional interest payment out of future cash flow. > > D)In a perfect no tax world, MM would tell you > that the firm’s weighted average cost of capital > (WACC) is increasing and the firm’s capital > structure will influence the firm’s stock price. MM would say capital structure is irrelevant. Equity costs may be rising, but they are offset by the tax sheild on the debt I think.
a. mwvt. impressive.
A for sure.
mwvt is reeeaaaadddy
mwvt9 Wrote: ------------------------------------------------------- > L2candidate777 Wrote: > -------------------------------------------------- > ----- > > Which of the following statements about capital > > structure theories is most accurate? > > >> > > > D)In a perfect no tax world, MM would tell you > > that the firm’s weighted average cost of > capital > > (WACC) is increasing and the firm’s capital > > structure will influence the firm’s stock > price. > > MM would say capital structure is irrelevant. > Equity costs may be rising, but they are offset by > the tax sheild on the debt I think. mwvt9 - most of your explanations are good…except the last option is a PERFECT NO TAX world…so there is no debt tax shield. The reason MM would consider capital structure is irrelevant is because there are no taxes, bankruptcy costs etc. Hence the proportion of debt vs equity is irrelevent (that’s Prop I) Prop II with no taxes is that as a company increases its use of debt, their cost of equity might increase. However as debtholders have a priority claim, the cost of debt will be lower than cost of equity. hence the wacc will even out.
mumukada Wrote: ------------------------------------------------------- > mwvt9 - most of your explanations are good…except > the last option is a PERFECT NO TAX world…so > there is no debt tax shield. The reason MM would > consider capital structure is irrelevant is > because there are no taxes, bankruptcy costs etc. > Hence the proportion of debt vs equity is > irrelevent (that’s Prop I) > > Prop II with no taxes is that as a company > increases its use of debt, their cost of equity > might increase. However as debtholders have a > priority claim, the cost of debt will be lower > than cost of equity. hence the wacc will even out. Right, thanks for that. I knew I had something wrong. That is why I put “I think”. I couldn’t remember why cost of equity would be going up with no taxes.
I agree with A.
definitely A.
This gotta be ‘A’ else I surrender.
A the other doesnt make much sense
A: Here’s why the the cost of capital doesn’t change in a perfect no tax world. If an investor bought the all the debt and equity of the firm, he’d get all the cash flows from the firm’s assets/operations. Varying the debt/equity ratio merely varies the amount of cash flow that goes to debt vs. equity. As long as the investor holds ALL the debt and euity, his cash flows are unchanged (in level and variability). If he holds only SOME of the debt and equity, the same effect holds as long as he holds them in proportion to the securities’ market values. Since the cost of capital is based on the riskiness of the underlying asset, this means that COC would be unchanged (in both cases, it’s based on the asset’s cash flows, and they’re unchanged) However, in a world with taxes but no bankruptcy, the cash flows to debt and equity increase with greater debt (the tax shield from greater interest deductions). This lowers the cost of capital. If there’s both taxes and bankruptcy costs, they kick in at different speeds - at low levels, the tax effect dominates (lowering cost of capital). As debt increases, the bankruptcy costs start to increase. At some point, the marginal effect of greater bankruptcy costs swamps the tax shelter effect. So, the cost of capital first drops (from the tax effect, and eventually rises (from the bankruptcy effect).