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# CH17 - CHAPTER 17 Does Debt Policy Matter Answers to...

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CHAPTER 17 Does Debt Policy Matter? Answers to Practice Questions 1. a. Rosencrantz could buy one percent of Company B’s equity and borrow an amount equal to: .01 (D A - D B ) = .002V where V is the total value of one firm (the firms have equal value). This investment requires a net cash outlay of .007V and provides a net cash return of: 0.1 Profits - .003 r V where r is the rate of interest on debt. Thus, the two investments are identical. b. Guildenstern could buy two percent of Company A’s equity and lend an amount equal to: .02 (D A - D B ) = .004V where V is the total value of one firm (the firms have equal value). This investment requires a net cash outlay of .018V and provides a net cash return of: .02 Profits - .002 r f V where r is the rate of interest on debt. Thus, the two investments are identical. c. The expected dollar return to Rosencrantz’ original investment in A is: .01 C - .003 r V A where C is the expected profit (cash flow) generated by the firm’s assets. Since the firms are the same except for capital structure, C must also be the expected cash flow for Firm B. The dollar return to Rosencrantz’ alternative strategy is: .01 C - .003 r V B Also, the cost of the original strategy is .007V A , while the cost of the alternative strategy is .007V B . 177

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If V A is less than V B , then the original strategy of investing in Company A would provide a larger dollar return at the same time that it would cost less than the alternative. Thus, no rational investor would invest in Company B, if the value of Company A were less than that of Company B. 2. When a firm issues debt, it shifts its cash flow into two streams. MM’s Proposition I states that this does not affect firm value if the investor can reconstitute a firm’s cash flow stream by creating his/her own leverage or by undoing the effect of the firms leverage by investing in both debt and equity. It is similar with Carruther’s cows. If the cream and skim milk go into the same pail, the cows have no special value. (If an investor holds both the debt and equity, the firm does not add value by splitting the cash flows into the two streams.) In the same vein, the cows have no special value if a dairy can costlessly split up whole milk into cream and skim milk (firm borrowing does not add value if investors can borrow on their own account). Carruther’s cows will have extra value if consumers want cream and skim milk and if the dairy cannot split up whole milk, or if it is costly to do so. 3. The company cost of capital is: r A = .8(.12) + .2(.06) = .108, or 10.8% This is unchanged by capital structure changes under Proposition I. With the bonds remaining at the 6 percent default-free level, we have: Debt-Equity Ratio r E r A 0.00 .108 .108 0.10 .113 .108 0.15 .120 .108 1.00 .156 .108 2.00 .204 .108 3.00 .252 .108 See Figure 17.6. 178
4. This is not a valid objection. MM’s Proposition II explicitly allows for the rates of return on both debt and equity to increase as the proportion of debt in the capital structure increases. The rate on bonds increases because the debt-holders are taking on more of the risk of the firm; the rate on the common stock increases because of increasing financial leverage.

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CH17 - CHAPTER 17 Does Debt Policy Matter Answers to...

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