Question

1. Explain the two Irrelevance Propositions advanced by Modigliani and Miller (M&M) in 1958. Give an intuitive argument for why these propositions are plausible. In contrast to the position of M&M, what is an Optimal Capital Structure? Describe the Static Trade-Off Theory that resulted from a synthesis of the work of M&M and their critics, carefully explain the elements that are being weighed in the decision.
2. What happens to a firm in Chapter 7 Bankruptcy? Describe the Absolute Priority Rule followed in Chapter 7.
How does Chapter 11 Bankruptcy differ fundamentally from Chapter 7? Broadly, describe the process for a Chapter 11 Bankruptcy. Describe the important features of a Feasible Business Plan under Chapter 11.
3. Jensen and Meckling (1976) also provide potentially important insights into the choice of Capital Structure. They discuss Agency Conflicts and the Costs associated with these. Describe the Agency Conflicts between Corporate Managers and the Stockholders of the firm. Next, describe the Agency Conflicts between the Bondholders and Stockholders of a firm. Be sure to describe how the level of debt in capital structure will affect both types of agency conflicts. Describe how the trade-offs between the different classes of Agency Conflicts and Costs may produce an Optimal Capital Structure in the context of Jensen and Mecklings’ framework. Explain Michael Jensen’s notions of what types of firms should employ high levels of debt, and which should not. Describe two common bond covenants, and explain how they help to ameliorate conflict between bondholders and stockholders.
4. According to the Pecking Order Theory of Stewart Myers, what is the pecking order that managers should follow in raising capital for investment? What exactly is the “cost” that Myers argues that managers should consider in raising capital, and why this is the relevant concern? Roughly, describe the magnitudes of these costs associated with the issue of various types of securities in the pecking order. Describe the Lemon Problem, advanced by George Akerloff, when there is informational asymmetry between two parties. When there are informational inefficiencies in markets, Myers argues that corporate actions send important signals to market participants.
Describe the signals that stock issues and bond issues might send to markets about the firms’ prospects and explain why. Correspondingly, how do markets react to announcements of these two types of security issues?

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Answer 1:
The first Irrelevance Proposition states that the fundamental value of the company cannot changed by merely changing its capital structure. This is because the financing decisions pertain to the mix of debt and equity to be deployed by the company and it does not affect the operations of the business. As per the second proposition, the fundamental cost of capital of the company cannot be altered by changing the capital structure of the company....

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