I have a basic understanding the MM theorems, but what exactly does one mean by a violation of the MM propositions?
Heres a question from a mock i took recently…
“The team suggests reducing the divident payout ratio from 40 to 20%. Despite how variable earnings can be the team belives that additional earnings retained b the firm will reduce debt to target levels in a 5 year time span and reduce the cost of equity as the debt is decreased”
Based on the MM propositions without taxes the statement is
A) Correct
B) Incorrect, as MM Prop 1 is violated
C) Incorrect becase MM Prop 1 and Prop 2 are violated
MM1: cap. structure doesn’t affect WACC, so changes are ignored
MM2: As debt increases, Ke also increases due to potential cost of financial distress. More debt in cap structure offset by higher Ke -> WACC is stationary.
I’d also go with A at this point, as the Q does not comment on a change in WACC, only Ke.
Agree with others. A seem like the best answer. I initially thought it was a cause I thought it had something to due with change WACC, which would violate MM2.
What the question said follows MM2, more debt = higher return on equity.
OP to violate MM1 no tax, the question would probably say something like reduce debt which lead to an increase or decrease in firm value.
Violating MM2 no tax would be like by changing the capital structure the WACC changed.