- CFA Exams
- CFA Level I Exam
- Topic 3. Corporate Issuers
- Learning Module 6. Capital Structure
- Subject 3. Modigliani-Miller Capital Structure Propositions
CFA Practice Question
Brandi's Back Yard Snacks is a highly profitable all-equity firm with a 35% tax rate. Management is considering issuing a small amount of debt and using the proceeds to retire some equity. The likely impact would be to ______
B. leave stock price unchanged.
C. increase stock price.
A. decrease stock price.
B. leave stock price unchanged.
C. increase stock price.
Correct Answer: C
The replacement of equity with debt will lever up the returns on equity and increase the EPS, but at the same time, the required rate of return will increase. In a world with taxes, the increase in EPS will dominate the increased cost of equity, and the stock price will rise.
User Contributed Comments 7
| User | Comment |
|---|---|
| shasha | the eps's domination keeps stock price climbing until its peak point, after that, based on M&M theory, bankruptcy cost turns to dominate and stock price turns to go down. high bankruptcy cost requires high rate of return. |
| setmefree | that should be the "trade-off" theory, since MM assumes no tax no bankruptcy cost |
| czar | Please could someone advise..where in the textbooks can i find the MM theory, please. |
| michlam14 | increased return due to increased leverage, decreased number of shares, meaning more return distributed to lower number of shares, increases EPS, increased profibility of the stock , hence increase share price |
| Kobe8kenji | MM theory can be found in all coporate finance textbook. |
| Kobe8kenji | except in CFA text :( |
| walterli | quantity goes down,price goes.....? |