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Question 99  capital structure, interest tax shield, Miller and Modigliani, trade off theory of capital structure

A firm changes its capital structure by issuing a large amount of debt and using the funds to repurchase shares. Its assets are unchanged.

Assume that:

  • The firm and individual investors can borrow at the same rate and have the same tax rates.
  • The firm's debt and shares are fairly priced and the shares are repurchased at the market price, not at a premium.
  • There are no market frictions relating to debt such as asymmetric information or transaction costs.
  • Shareholders wealth is measured in terms of utiliity. Shareholders are wealth-maximising and risk-averse. They have a preferred level of overall leverage. Before the firm's capital restructure all shareholders were optimally levered.

According to Miller and Modigliani's theory, which statement is correct?




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