CHAPTER 17
Does Debt Policy Matter?
Answers to Practice Questions
1.
a.
The two firms have equal value; let V represent the total value of the firm.
Rosencrantz could buy one percent of Company B’s equity and borrow an
amount equal to:
0.01
×
(D
A
- D
B
) = 0.002V
This investment requires a net cash outlay of (0.007V) and provides a net
cash return of:
(0.01
×
Profits) – (0.003
×
r
f
×
V)
where r
f
is the risk-free 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:
0.02
×
(D
A
- D
B
) = 0.004V
This investment requires a net cash outlay of (0.018V) and provides a net
cash return of:
(0.02
×
Profits) – (0.002
×
r
f
×
V)
Thus the two investments are identical.
c.
The expected dollar return to Rosencrantz’ original investment in A is:
(0.01
×
C) – (0.003
×
r
f
×
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:
(0.01
×
C) – (0.003
×
r
f
×
V
B
)
Also, the cost of the original strategy is (0.007V
A
) while the cost of the
alternative strategy is (0.007V
B
).
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.
151

This
** preview**
has intentionally

**sections.**

*blurred***to view the full version.**

*Sign up*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 personal leverage or by
undoing the effect of the firm’s 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
= (0.8
×
0.12) + (0.2
×
0.06) = 0.108 = 10.8%
Under Proposition I, this is unaffected by capital structure changes.
With the
bonds remaining at the 6 percent default-risk free rate, we have:
Debt-Equity
Ratio
r
E
r
A
0.00
0.108
0.108
0.10
0.113
0.108
0.50
0.132
0.108
1.00
0.156
0.108
2.00
0.204
0.108
3.00
0.252
0.108
See figure on next page.

This is the end of the preview.
Sign up
to
access the rest of the document.