Finance 414 – Fall 2018 – Problem Set #2 – Solutions
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.
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.
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.
First note that firm A is levered, firm B is unlevered, and each firm has a market value of
Thus, the Modigliani and Miller proposition I result in a world with no taxes
A $4 million investment in firm A entitles the investor to 2.5% of the cash flows of firm
A's assets after interest