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Unformatted text preview: 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 ´ rf ´ VB) Also, the cost of the original strategy is (0.007VA) while the cost of the alternative strategy is (0.007VB). If VA is less than VB, 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 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 an...
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This note was uploaded on 04/26/2013 for the course MATH 289Q taught by Professor Jamesbridgeman during the Fall '04 term at UConn.

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