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Unformatted text preview: Chapter 15 Capital Structure Decisions: Part II ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 15-1 Arbitrage is generally thought of as the process of buying an item in one market and simultaneously selling it at a higher price in another market and thus earning a riskless profit. MM broadened this concept. They show, under a set of assumptions, that personal debt can be used to cause the risk of two different stocks to be the same but the returns on the stocks can be different. Then, one could buy the cheaper stock and simultaneously sell the more expensive one and end up earning a riskless profit. Using this arbitrage concept, they demonstrated that if an unleveraged firm had a higher value that a leveraged firm, then investors could use “homemade” leverage to earn a riskless profit by selling the leveraged firm’s stock and borrowing to buy stock in the unleveraged firm’s stock. So, investors would get to the same debt position and have the same risk, but earn a higher profit. The MM conclusions were based on a number of assumptions, and in the real world, those assumptions are not correct. Investors cannot necessarily borrow at the same rate as corporations, interest rates increase with the amount borrowed, bankruptcy costs do exist, and so on. Moreover, corporations are more likely to use cash flows to service their own debt than they are to pay dividends in bad times to enable stockholders to service “homemade” leverage debts, which could result in additional risk to the personally leveraged investor. It should be noted that many of the arguments against the MM assumptions are valid if one thinks about individual investors like college professors but less valid if the “investor” is an institutional investor like a pension fund that has ready access to capital and may not have to pay taxes. Then, taxes and brokerage costs may really be immaterial, borrowing costs may be the same for the investor and the company, the investor and the firm may have the same information, and the investor may have enough clout to force the company to provide cash to service the investor’s debt. As a result, arbitrage undoubtedly works better for certain large investors than for small investors. The use of debt in corporate America increased after MM published their work, and we believe that MM’s work contributed to this development. 15-2 Miller added personal income taxes to the MM equation. He argued (1) that the personal tax rate was high on interest income and dividends but much lower on capital gains income, and (2) that individuals could use various tax shields, including death, to avoid capital gains taxes, while corporations could retain earnings, use stock buy-back programs, and so on to help stockholders minimize personal taxes on income from stock. Miller’s conclusion was that investors could essentially avoid taxes on stock income, hence they had a much lower risk-adjusted Answers and Solutions: 15 - 1 required rate of return on stocks than on bonds, and that this...
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This note was uploaded on 06/17/2008 for the course FIN 4309 taught by Professor Dt during the Spring '08 term at UCLA.
- Spring '08