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27 Nov 2019

How would you answer in the following debate?

Question:

Isn't it true that the riskiness of a firm's equity will rise if the firm increases its use of debt financing?

Answer:

Yes, that's the essence of the MM proposition 2.

Question:

And isn't it true that, as a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the risk of the firm's debt?

Answer:

Yes.

Question:

In other words, increased borrowing increases the risk of the equity and the debt?

Answer:

Thats right.

Question:

well, given that the firm uses only debt and equity financing, and given that the risks of both are increased by increased borrowing, does it not follow that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm?

Answer:?

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Irving Heathcote
Irving HeathcoteLv2
7 Jul 2019
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Related questions

1.Fixed cost sources of financing include both debt and common stock.

True

False

2.The desire to maintain high bond ratings will tend to increase the use of debt financing in a firm’s capital structure.

True

False

3. Financial risk is the basic risk inherent in the operations of a firm. It can be viewed as the volatility of a firm’s EBIT.

True

False

4. As a firm increases its use of debt financing, what is the impact upon the cost of equity?

The cost of equity decreases.

The cost of equity remains the same.

The cost of equity increases.

None of the above.

5.An investment banking firm has estimated the following after-tax cost of debt and cost of equity for Marquez Luxury Travel Tours.

Proportion of Debt After-tax Cost of Debt Cost of Equity

30% 3.5% 10.5%

40% 3.8% 11.3%

50% 5.0% 12.9%

60% 7.2% 14.5%

What is the cost of capital at Marquez’ optimal capital structure given the above information?

8.95%

8.40%

8.30%

8.15%

6. How does high business risk affect firm risk?

Higher business risk increases the volatility of capital structure.

Higher business risk increases the volatility of EBIT.

Higher business risk increases the volatility of financial costs.

Higher business risk increases the volatility of the firm’s asset structure.

Which of the following are true about the relation between debt and equity financing? (choose all that apply)

The cost of debt is always less than the cost of equity.

The cost of equity always decreases as the debt-to-equity ratio increases.

Increasing the use of debt does not always decrease the weighted average cost of capital.

Highly levered firms do better in recessions than all equity firms.

Increasing the tax rate will increase the value of the interest tax shield but lower the value of equity.

Increasing the tax rate will increase the cost of equity.

According to the Pecking order hypothesis, increasing the tax rate will cause firms to issue more debt.

Which of the following statements regarding Modigliani and Miller (MM)’s propositions is most accurate?

A.

Firm value is maximized with a capital structure consisting of 100% equity

B.

The required rate of return of equity increases as the firm increases its financial leverage

C.

The use of debt financing increases the firm’s earnings volatility

D.

It does not matter which capital structure firm choose because capital structure is irrelevant in terms of firm value, with or without taxes.

E.

All of above are wrong

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