Question

please answer both

QUESTION 11 Modigliani and Miller's Irrelevance Hypothesis assumes that there are no taxes, no costs of financial distress, no asymmetric information between investors and corporate executives, etc. When those assumptions we relaxed so that they are more consistent with the real world there are corporate taxes and interest payments are tax deductible) and there are costs of financial distress - then which of the following is true? Each firm has an optimal capital structure where firm value is minimized. Firm value increases and WACC cases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial stress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to decrease as more debt is added. Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that cutweigh the benefits of further reducing taxes. After this point, fimile starts to decrease and WACC starts to increase as more debt is added. Each firm has an optimal capital structure where WACC is maximized Firm value and WACC are independent of the firm's capital structure QUESTION 12 Your bank offers a savings account with a 8.5% APR compounded monthly (12 months in the year). If you invest $1,000 in this account, how much will you have after 5 years? 1.425.00 1,479.37 1,501.86 1,527.30 1,533.57

Answer 1

11 Answer: Option (3)

Irrespective of any assumption, WACC = (We * Ke) + (Wd *Kd), hence, Firm Value and WACC is not independent of Firm's Capitalstructure, i.e., Firm Value and WACC are dependet on Capital Structure.

Firm's Optimal Capital Structure is at the level of debt where WACC is minimum, at optimum Level of Capital Structure, Firm Value is at its maximum.

As there will be tax saving on Interest payment on debt, Cost of debt will be lower when comppaed to Cost of Equity, hence on employment of debt initially, WACC decreases and Firm Value increases. However at a particular level the financial distress costs overweigh the tax benefit on interest payments due to employment of debt due to which any additional debt results in increase of WACC and reduction in Firm Value due to inefficient usage of Capital Structure.

Hence, Option (3) is correct.

12 Answer: Option (4) $ 1,527.30

Amount Depoited = $ 1,000

Interest Rate = APR 8.5% Compounded Monthly

Time = 5 years

Amount in Savings Account after 5 years = P(1+i)^n

Amount in Savings Account after 5 years = $ 1,000 (1+(0.085/12))^(5*12)

Amount in Savings Account after 5 years = $ 1,000 (1.007083)^60

Amount in Savings Account after 5 years = $ 1,000 * 1.52730

Amount in Savings Account after 5 years = $ 1,527.30