Alternatively we could have borrowed 1 of firm ls

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Unformatted text preview: must be equal to the value of Firm L. In summary, firm value is independent of the debt policy. Consider an alternative investment strategy where we consider investing only in 1 percent of L’s equity. Alternatively, we could have borrowed 1% of firm L's debt, DL, in the bank and purchased 1 percent of Firm U. The investment in 1% of Firm L's equity yields 1% of the profits after interest payment in return. Similarly, borrowing 1% of L's debt requires payment of 1% of the interest, whereas investing in 1% of U yields 1% of the profits. Investment Return 1% of Firm L's equity 1% · EL = 1% · (VL - DL) 1% · (Profits - Interest) Borrow 1% of Firm L's debt and purchase 1% of Firm U - Borrow 1% of L's debt - 1% of U's equity -1% · DL 1% · EU = 1% · VU -1% · Interest 1% · Profits = 1% (VU - DL) = 1% · (Profits - Interest) It follows from the comparison that both investments return 1% of the profits after interest payment. Again, as the profits are assumed to be identical, the value of the two investments must be equal. Setting the value of investing 1% in Firm L's equity equal to the value of borrowing 1% of L's debt and investing in 1% of U's equity, yields that the value of Firm U and L must be equal - 1% · (VL - DL) = 1% · (VU - DL) VL = VU The insight from the two examples above can be summarized by MM's proposition I: Miller and Modigliani's Proposition I...
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This note was uploaded on 10/26/2012 for the course 19 19 taught by Professor - during the Spring '12 term at Sunway University College.

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