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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
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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- Fall '04