Question

1. Assume the M&M framework. Currently, a firm has Debt = $2,000. Its stockholders have a mean return of 0.15 and a standard deviation of returns of 0.20. Suppose the firm increases its debt to $4,000. The standard deviation of returns to stockholders would:

a. Not change

b. Increase

c. Decrease

2.Assume the M&M framework. Suppose R₀ = .20, R_B = .05, t_C = .2, B = $2,000 and S = $4,000. What is R_S?

a. 0.29

b. 0.22

c. 0.26

d. 0.17

3. Assume the M&M framework. A firm substitutes $10,000 of equity for $10,000 of debt (i.e., it now has more equity and less debt). If there are no taxes, firm value would:

a. Increase

b. Decrease

c. Stay the same

Answer 1

^{Modigilani & Miller Hypothesis:}

^{M & M Theory is in support of IRRELEVANCE OF DIVIDENDS in the organisation.}

^{It States that dividend policy has no effect on its value of assets i.e., dividends are irrelevant to shareholders wealth.}

^{THUMB RULE : M & M Approach is based on Net Operating Income ( Net Operating Profit After Tax - NOPAT)}

^{The only that impacts is the earning of the company over its investments. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity or a mix of both debt and equity. Funding via DEBT & EQUITY has their own advantages and disadvantages.}

^{Various Capital theories explain the relationship between financial leverage ( Proportion of debt & Equity ) with its market Value.}

^{This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component in the financing mix, it has no bearing on the value of a firm.Thus, the Modigliani – Miller theory firmly states that the dividend policy of a company has no influence on the investment decisions of the investors.This theory also believes that dividends are irrelevant by the arbitrage argument. By this logic, the dividends distribution to shareholders is offset by the external financing. Due to the distribution of dividends, the price of the stock decreases and will nullify the gain made by the investors because of the dividends.}

^{FORMULA : P1 = P0 * (1 + ke) – D1.}

_{P1 = market price of the share at the end of a period}

_{P0 = market price of the share at the beginning of a period}

_{ke = cost of capital}

_{D1 = dividends received at the end of a period}

^{A) M & M is Primarily based on arbitrage argument. Through arbitrage process, The MM Hypothesis discusses how the frm value of the firms remains the same irrespective payment of dividend.It argues the value of the depends on the earning of the firm and is unaffected by income distribution..}

^{Suppose a firm which pays dividend will have to raise funds externally to finance its investment plans , M&M states that the dividend policy does not affect the wealth of shareholders implies that firm pays dividend ,its advantage is off set by external financing.Thus wealth of shareholders- DIVIDEND + Terminal Value unchanged.As s result the PV per share after dividends and external financing is equal to PV per share before payments of dividend.}

^{Thus Shareholders are indifferent between payments of dividends and retention of earnings.The Modigliani and Miller Approach assumes that there are no taxes. But in the real world, this is far from the truth. Most countries, if not all, tax a company. This theory recognizes the tax benefits accrued by interest payments. The interest paid on borrowed funds is tax deductible. However, the same is not the case with dividends paid on equity. To put it in other words, the actual cost of debt is less than the nominal cost of debt because of tax benefits. The trade-off theory advocates that a company can capitalize its requirements with debts as long as the cost of distress i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus, the increased debts, until a given threshold value will add value to a company.Thus we can say that the valuation of a firm is irrelevant to the capital structure of a company .Whether a firms is highly leveraged or has lower debts component in the financing mix, it has no bearing on the value of the firm.}

1 ) Remains unchanged because the firms value is affected with proportion of financial mix between debt and equity according to M&M Approach.

3) Value of the firms remains unchanged because it would cause affect to NOPAT

( M&M based on assumption of Taxes)