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7nswer: FoneH
&hy is MM so important'
However) when you lever up) the equity becomes riskier and
requires an even higher return. These two effects e$actly
cancel.
ffect of leverage on returns
in the MM "orld
;isk of equity:
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return on a##et#
;eturns and leverage
Debt become# ri#ky Debt/Equity
E%&ected
'eturn#
r
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r
D
r
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Do "e believe the MM
assumptions'
etc.
Ta$es
-ther !rictions
4ela5ing the /ssumptions of
MM
;isk'free rate is :=
3orporate ta$ rate "T
3
# is *:=.
>
5
@ value of the levered firm
>
4
@ value of the unlevered firm
Here "and in general# keeping e$cess
cash in firm is like having negative debtH
&here do "e stand no"'
.eems e$treme:
' 7verage debt ratio has been around (0= in last decades.
' Cany firms "Cicrosoft) &ntel# hoard large amount of cash.
+ither 3!-Ds are missing something) or something must be
missing from our analysis.
D/E
Firm*# value
In addition7 most firms effectively pay less
than the statutory rate in corporate ta5es
Goom: 1 @ ! @ 0:) + @ 0:
.o today: 1 @ (0) + @ %0
&nvest : today
Goom: 1 @ 0:) + @ Q0
Gust: 1 ? (0) + @ :
Today:
+quity gets the upside) but does not bear the full
downside
Goom: 1 @ ! @ 0:) + @ 0:
.o today: 1 @ (0) + @ %0
Gust: > @ %: ? : I :) 1 @ :) + @ :
Today:
+ @ %9) increase by *
=
+
0
) 1 (
* ) Pr(
t
t
t t
r
Costs distress
)ractical Implications