Solved by verified expert :QUIZ: CAPITAL STRUCTURE
1 of 4
The
Modigliani and Miller (MM) proposition 2 highlights the fact that, as the level
of debt in a company’s capital structure rises, the expected return on the
company’s assets RISES, FALLS OR REMAINS THE SAME? while the
required return on equity RISES, FALLS OR
REMAINS THE SAME?.
2 of 4
Default
risk is the risk of a company not being able to pay back its debt.
a) Default
risk IS OR IS
NOTrecognised in Earnings Before
Interest and Tax (EBIT)-Earnings Per Share (EPS) analysis.
b) Default
risk is an important consideration in EBIT/EPS analysis because it means that:
having
high levels of debt will generate an overinflated EPS figure
maintaining
low levels of debt is often impossible
issuing
shares will always be preferable to issuing debt
issuing
more debt to maximise EPS will not always be beneficial
3 of 4
The
trade-off theory of capital structure implies that for a company incorporating
both debt and equity into its capital structure:
there
exists a trade-off between total expenses and debt levels.
the
company should try to eliminate all debt from the capital structure.
the
more debt the company issues, the less risky it becomes.
there
exists an optimal leverage level for that company.
4 of 4
The tax
savings on interest for a company that incorporates debt into its capital
structure is equal to:
company
tax rate x interest expense
debt
interest rate x taxable income
(1 –
company tax rate) x interest expense
(1 –
debt interest rate) x taxable income
