Finance and Debt

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MM Propositions:In a world with no taxes, no transaction costs, and no costs of financial distress, is the following statement true, false, or uncertain? Moderate borrowing will not increase the required return on a firm’s equity. Explain.

MM Proposition II states that higher debt does not affect cost of capital of a firm. The reason is that the lower cost of debt is offset by a greater cost of equity, which means investors demand a higher return on equity as a result of the higher risk coming with more debt, that holds the firm’s cost of capital unchanged.

Based on the above proposition, moderate borrowing may not increase the return on equity. It is suggested that the firm’s capital structure (proportions of debt and equity) is irrelevant to wealth maximization of stockholders. Managers cannot alter the value of the firm by changing the proportion of the firm’s debt and equity in order to increase the required return. .The value of the firm is determined by the firm’s capital budgeting decisions. Capital structure determines only the proportion of debt and equity in the firm.

Increasing the extent to which a firm uses debt increases both the risk to stockholders and the return they require. On the other hand, higher levels of debt also carry higher costs, which lowers the return on equity. The first cost is the higher financial distress. When the firm’s segment of operating earnings which is related to debt payments increases, its probability of financial distress increases in turn. Given a certain level of debt payments, firms with more volatile operating earnings (a riskier profile) will face a higher outcome of financial distress.

Therefore, the above statement can be applied in general situations. In realty, it is uncertain and controversial.
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