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Unformatted text preview: d 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: rA = (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 default­risk free rate, we have: Debt­Equity rE rA Ratio 0.00 0.10 0.50 1.00 2.00 3.00 0.108 0.113 0.132 0.156 0.204 0.252 0.108 0.108 0.108 0.108 0.108 0.108 See figure on next page. 4. This is not a valid objection. MM’s Proposition II explicitly allows for the rates of return for both debt and equity to increase as the proportion of debt in the capital structure increases. The rate for debt increases because th...
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