Question
Identify the relevant changes resulting from the following independent scenarios. Focus on capital structure effects only and ignore any other indirect effects on the business.
Identify the relevant changes resulting from the following independent scenarios. Focus on capital structure effects only and ignore any other indirect effects on the business.
a) Firm X takes out a loan to repurchase shares. Assume that all Modigliani and Miller assumptions hold. (2 Marks)
Firm value will: Answer increase/decrease/remain unchanged
Cost of equity will: Answer increase/decrease/remain unchanged
Weighted average cost of capital will: Answer increase/decrease/remain unchanged
The present value of tax shields will: Answer increase/decrease/remain unchanged
b) Firm Y issues shares to repay debt. Assume the existence of corporate tax, but no information or transaction costs. (2 Marks)
Firm value will: Answer increase/decrease/remain unchanged
Cost of equity will: Answer increase/decrease/remain unchanged
Weighted average cost of capital will: Answer increase/decrease/remain unchanged
The present value of tax shields will: Answer increase/decrease/remain unchanged
c) The corporate tax rate suddenly increases by a material amount. Assume no information or transaction costs. Consider the resulting capital structure effects only. (2 Marks)
Firm value will: Answer increase/decrease/remain unchanged
Cost of equity will: Answer increasedecreaseremain unchanged
Weighted average cost of capital will: Answer increasedecreaseremain unchanged
The present value of tax shields will: Answer increasedecreaseremain unchanged
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