pset2answers.docx - Finance 414 Fall 2018 Problem Set#2...

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Finance 414 – Fall 2018 – Problem Set #2 – Solutions #1. Disagree. If you issue equity and repurchase debt it is true that the shares will be less risky. However, the expected return on the shares will also decrease. The MM theory implies that the decrease in risk is exactly offset by the decrease in expected return and thus share values do not change when leverage changes. #2. According the MM, the value of Spartan and Wolverine must be the same. Spartan's market value is (80 x 10 mil. + 400 mil.) = \$1,200 mil. Since the market value of Wolverine's bonds is \$200 million, the market value of Wolverine's equity must be: (total firm value minus bond value) = (\$1,200 mil. - \$200 mil.) = \$1,000 million. If Wolverine's equity is worth \$1,000 million and they have 10 million shares outstanding, the market price of those shares must be (\$1,000 mil./10 mil.) = \$100 per share. #3. (a) First note that firm A is levered, firm B is unlevered, and each firm has a market value of \$200 million. Thus, the Modigliani and Miller proposition I result in a world with no taxes holds. A \$4 million investment in firm A entitles the investor to 2.5% of the cash flows of firm A's assets after interest .