Companies that use debt in their capital structure are said to be using hinandal leverage. leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear. Consider the following case: Red Snail Satellite Company is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 40%. Assuming that the project generates an expected EBIT (earnings before interest and taxes) of $150,000, then Red Snail's anticipated ROE (return on equity) for the project will be: 8.36% 12.86% 10.93% 13.50% In contrast, assume that the project's EBIT is only $45,000. When calculating the tax effects, assume that the entire Red Snail Satellite Company will earn a large, positive income this year. The resulting ROE will be 4.48% 3.90% Now consider the cas Black Sheep Broadcasting Company: 4.48% Black Sheep Broadca 4.29% mpany is considering implementing a project that is identical to that being evaluated by R 3.32% although Black Sheep wants to finance the $700,000.00 in additional assets using s0%dquity and 50% debt capital. The interest rate on Black Sheep's new debt is expected to be 13%, and the project is forecasted to penerate an EBIT of $150,000. As a result, the project is expected to generate a ROE of Now assume that Black Sheep finances the same project with 50% debt and 50% equity capital, but expects it to generate an EBIT of only $45,000. Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project (with its resulting tax saving) will be offset by the company's other (positive) income. Remember, the interest rate on Black Sheep's debt is 13%. Under these conditions, it is reasonable to expect that Black Sheep will generate a ROE of: -0.12% -0.1% -0.09% -0.13% Given the ROE-related findings above for both Red Snail and Black Sheep, answer the following question: the The use of financial leverage decreases a a firm's expected RDE. probability of a large loss, and consequently the risk borne by the firm's stockholders. The greater a firm's chance of bankruptcy, the its optimal debt ratio will be manager is more likely to use debt in an effort to boost profits In 1958 Franco Modigliani and Merton Miller (MM) published a set of research papers that revolutionized the theory of a corporation's capital structure. In their first research paper, MM proposed a set of assumptions that, on the surface, may seem unrealistic, but these assumptions and MM's algebraic approach provided the first significant attempt to study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved. Which of the following statements are assumptions that Modigliani and Miller used in their initial (MM Proposition I) model and research paper? Check all that apply. The cost of debt increases with the level of debt. There are no taxes--either personal or corporate. Investors have different expectations about firms' earnings and risk. There are no costs associated with a bankruptcy. Complete information is readily available to all investors and igree to all market participants. All investors are rational, and have the same expectations of a company's earnings (as measured by its EBIT). Consider the following statement about a firm's capital structure: A firm's capital structure does not affect the firm's market value Is the preceding statement consistent with the conclusions of Modigliani and Miller's 1958 capital structure theory (MM Proposition !)? Yes Companies that use debt in their capital structure are said to be using hinandal leverage. leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear. Consider the following case: Red Snail Satellite Company is considering a project that will require $700,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 40%. Assuming that the project generates an expected EBIT (earnings before interest and taxes) of $150,000, then Red Snail's anticipated ROE (return on equity) for the project will be: 8.36% 12.86% 10.93% 13.50% In contrast, assume that the project's EBIT is only $45,000. When calculating the tax effects, assume that the entire Red Snail Satellite Company will earn a large, positive income this year. The resulting ROE will be 4.48% 3.90% Now consider the cas Black Sheep Broadcasting Company: 4.48% Black Sheep Broadca 4.29% mpany is considering implementing a project that is identical to that being evaluated by R 3.32% although Black Sheep wants to finance the $700,000.00 in additional assets using s0%dquity and 50% debt capital. The interest rate on Black Sheep's new debt is expected to be 13%, and the project is forecasted to penerate an EBIT of $150,000. As a result, the project is expected to generate a ROE of Now assume that Black Sheep finances the same project with 50% debt and 50% equity capital, but expects it to generate an EBIT of only $45,000. Further assume that the company as a whole will generate a large, positive income this year, such that any loss generated by the project (with its resulting tax saving) will be offset by the company's other (positive) income. Remember, the interest rate on Black Sheep's debt is 13%. Under these conditions, it is reasonable to expect that Black Sheep will generate a ROE of: -0.12% -0.1% -0.09% -0.13% Given the ROE-related findings above for both Red Snail and Black Sheep, answer the following question: the The use of financial leverage decreases a a firm's expected RDE. probability of a large loss, and consequently the risk borne by the firm's stockholders. The greater a firm's chance of bankruptcy, the its optimal debt ratio will be manager is more likely to use debt in an effort to boost profits In 1958 Franco Modigliani and Merton Miller (MM) published a set of research papers that revolutionized the theory of a corporation's capital structure. In their first research paper, MM proposed a set of assumptions that, on the surface, may seem unrealistic, but these assumptions and MM's algebraic approach provided the first significant attempt to study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved. Which of the following statements are assumptions that Modigliani and Miller used in their initial (MM Proposition I) model and research paper? Check all that apply. The cost of debt increases with the level of debt. There are no taxes--either personal or corporate. Investors have different expectations about firms' earnings and risk. There are no costs associated with a bankruptcy. Complete information is readily available to all investors and igree to all market participants. All investors are rational, and have the same expectations of a company's earnings (as measured by its EBIT). Consider the following statement about a firm's capital structure: A firm's capital structure does not affect the firm's market value Is the preceding statement consistent with the conclusions of Modigliani and Miller's 1958 capital structure theory (MM Proposition !)? Yes