- Homework Solutions
- Homework Questions & Answers
Well with your expectation for the answers, it is impossible to answer the questions i.e. each to be 2 pages as the limit here is 1000 words.
I will share some insight in one paragraph, which you can put in your own words as you like.
a. Modigliani and miller's capital structure propositions with tax assumption:
-MM theory is focused on identifying the optimal capital structure.
-When there are taxes included,
(i) the value of a levered company(company with some debt in the total asset) is always higher than an un-levered company(company with no debt or all equity) and
(ii) the cost of equity increases proportional to debt to equity(D/E) ratio and tax rate(t).
-Proposition 1: Value of levered company = Value of Un-Levered company + (Debt amount * Tax rate)
-Proposition 2: To identify the weighted avg. cost of capital i.e. WACC = (Cost of Equity * (Equity / total Asset) + (Cost of Debt * (Debt / total Asset) * (1-tax rate)
** (1-tax rate) is also call as tax shield which provides decrease in effective cost of debt due to the presence of tax for the debt amount.
-Conclusion: The value of a company with debt(levered company) is higher than the value of a company with no debt(Un-levered company).
b. Why companies would consider paying a dividend:
-Dividend is a way of sharing the profit to the shareholders when the is doing good.
-When a company is just started it would require funds to expand and maximize its output.
-so when a company is still growing phase (until maturity) it won't pay dividends or pay less dividends because it expects to invest as much as possible
into the further growth. Companies may use the money to start a new project, acquire new advanced assets, repurchase some of their shares or even buy out other benefiting company.
-But when the companies need to share the dividend, it means; investors will be more interested to buy the company's stock, investors also see the dividend payment
as a sign of a company's strength and a sign that the management has a positive expectation for future earnings, which again makes the stock more attractive for budding investors.
A greater demand for the stock will increase its market price and add more benefit to the company.
c. Positive NPV project is not the only way to go for the investment
-NPV estimates the the future cash flows and there by estimates the companies cost of capital
-When the investment amount of a project is different or at a higher side of the company that is taking over it is expected that there would be infrequent CFs which is not taken into consideration in NPV\
-The assumption of the life span of the project is infrequent, in case the life span is high enough economic or political impact is not taken into consideration,
in case the life span is too low the profit expectation time period is too low.
-Conclusion: NPV is comparison tool which does not mean that when there is a project it will ideally give the return that is expected out of it.
Hope this helps. In case you find it helpful then give a thumbs up.
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