Chapter 16 | Capital Structure: Basic Concepts

What are the assumptions of MM Propositions with Corporate Taxes

1. Corporations are taxed at the rate TC on earnings after interest 2. There are no transaction or bankruptcy costs. 3. Individuals and corporations borrow at the same rate

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___.

A higher expected return

MM Proposition I

Because corporations can deduct interest payments but not dividend payments, corporate leverage lowers tax payments

Which of the following assumptions is necessary for MM Proposition I to hold? Individuals can borrow on their own at an interest rate equal to that of the firm. Managers must be acting to maximize the value of the firm. Interest rates must be low. Personal taxes must be lower than corporate taxes.

Individuals can borrow on their own at an interest rate equal to that of the firm.

A company should select the capital structure that ___.

Maximizes the company's value

An increase in the value of a previously all-equity firm occurs when debt is borrowed to repurchase stock because ___.

Shareholders capture the interest rate tax shield

The manager of a firm should change the capital structure if and only if ___.

The change will increase the value of the firm

MM Proposition II

The cost of capital of levered equity increases with the firm's market value debt-equity ratio

A firm's capital structure refers to___

The firm's mix of debt and equity

Why does the tax shield have value?

The tax shield has value because it reduces the stream of future taxes.

True or False: Leverage almost always increases risk.

True

An unlevered firm ____.

has an all-equity capital structure

A key assumption of MM Proposition I is that ___.

individuals can borrow as cheaply as corporations

The expected return on equity is ___ to leverage.

positively related

Volatility or ______ increases for equity holders when leverage increases.

risk