CH18 - CHAPTER 18 Does Debt Policy Matter? Answers to...

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CHAPTER 18Does Debt Policy Matter?Answers to Practice Questions9.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 anamount equal to:0.01(DA- DB) = 0.002VThis investment requires a net cash outlay of (0.007V) and provides a netcash return of:(0.01Profits) – (0.003rfV)where rfis the risk-free rate of interest on debt.Thus, the two investmentsare identical.b.Guildenstern could buy two percent of Company A’s equity and lend anamount equal to:0.02(DA- DB) = 0.004VThis investment requires a net cash outlay of (0.018V) and provides a netcash return of:(0.02Profits) – (0.002rfV)Thus the two investments are identical.c.The expected dollar return to Rosencrantz’ original investment in A is:(0.01C) – (0.003rfVA)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 bethe expected cash flow for Firm B.The dollar return to Rosencrantz’alternative strategy is:(0.01C) – (0.003rfVB)Also, the cost of the original strategy is (0.007VA) while the cost of thealternative strategy is (0.007VB).If VAis less than VB, then the original strategy of investing in Company Awould provide a larger dollar return at the same time that it would cost lessthan the alternative.Thus, no rational investor would invest in Company Bif the value of Company A were less than that of Company B.18-1
10.When a firm issues debt, it shifts its cash flow into two streams.MM’sProposition I states that this does not affect firm value if the investor canreconstitute a firm’s cash flow stream by creating personal leverage or byundoing 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 samepail, the cows have no special value.(If an investor holds both the debt andequity, the firm does not add value by splitting the cash flows into the twostreams.)In the same vein, the cows have no special value if a dairy cancostlessly split up whole milk into cream and skim milk.(Firm borrowing does notadd value if investors can borrow on their own account.)Carruther’s cows willhave extra value if consumers want cream and skim milk and if the dairy cannotsplit up whole milk, or if it is costly to do so.11.a.The market price of the stock is not affected by the announcement.b.Since the market price of the shares is $10, the company can buy back:$160 million/$10 = 16 million sharesc.After the change in capital structure, the market value of the firm isunchanged:Equity + Debt = (9 million$10) + $160 million = $250 milliond.After the change in structure, the debt ratio is:Debt/(Debt + Equity) = $160 million/$250 million = 0.64

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Term
Spring
Professor
TDK
Tags
Corporate Finance, Debt, Interest, Modigliani Miller theorem, Weighted average cost of capital

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