ch15boc-model - 04/22/2011 07:19:49 A 1 2 3 4 5 6 7 8 9 10...

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04/22/2011 07:19:49 1 of 5 Worksheet for Chapter 15 BOC Questions. Capital Structure Decisions: Part 2. 3/17/03 Modigliani and Miller Without Taxes Proposition I. 1. The weighted average cost of capital is independent of the firm's capital structure. 2. The WACC of a firm with debt is equal to the unlevered cost of equity. Proposition II. Input Data Firm U Firm L No Debt Some Debt EBIT $500,000 $500,000 Debt $0 $3,000,000 NA 6.0% 8% 8% Tax rate 0% 0% Value of Stock $6,250,000 $4,000,000 Total Market Value of Firm $6,250,000 $7,000,000 Value of Firm = Value of Stock + Value of Debt Buy Borrow amt. Invest extra Portfolio of U, Old 10% of equal to 10% $75,000 in risk Debt, and risk Investment, U's Stock of L's Debt free asset @ 6% free asset 10% of L Cost $625,000 ($300,000) $75,000 $400,000 $400,000 Income $50,000 ($18,000) $4,500 $36,500 $32,000 The cost of equity, r sL , is found as follows: rsL= r sU + Risk premium = r sU + (r sU -r d )(D/S) Supposethe costs of equity for Firms U and L are as follows: r sL = r sU = 8%. k d k s Value of Stock = (EBIT - r d D)/r S Now compare an investment in L with a derivative investment which duplicates L's leverage by borrowing and buying U's stock. Assume that the investor owns 10% of L's Stock which is sold for $400,000 . Notice that for the same $400,000 investment, you can get $4,500 more in annual income from a portfolio of U and "homemade debt" than from an investment in L. MM argue that this can't persist--that investors will sell L and buy U to form the portfolio, driving the price of L down and U up, until the arbitrage opportunity vanishes. A B C D E F G H 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43
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04/22/2011 07:19:49 2 of 5 cost of the portfolio of U and borrowing will be equal to the cost of L, and the income from the portfolio will equal the income from L, and no arbitrage opportunity will exist. Modigliani and Miller with CorporateTaxes
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This note was uploaded on 04/22/2011 for the course BBA FIN 423 taught by Professor Mahmudulhaque during the Spring '11 term at BRAC University.

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ch15boc-model - 04/22/2011 07:19:49 A 1 2 3 4 5 6 7 8 9 10...

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