B3. Debt policy (Answer all parts of this question.) (a) (4P) Assume that we have perfect and efficient capital markets, no taxes, and no asymmetric information. What are the two main theorems for i. capital structure and ii. cost of equity capital according to Modigilani-Miller? Give a brief answer. (b) Companies A and B differ only in their capital structure. Company A is financed 30 percent debt and 70 percent equity; Company B is financed 10 percent debt and 90 percent equity. The debt of both companies is risk free. Mr Miller owns 1 percent of the common stock of company A, (EA). Show that an investment in 1% of the common stock of company B (EB) and borrowing an amount equal to 1% of the difference in total debt of both companies, DA - DB i. (5P) costs the same, and ii. (5P) yields identical returns to his investment in 1% of the common stock of company A, (EA). Assume that the theorems of Modigilani-Miller hold. (c) (6P) In real life, firms are subject to corporate taxes. What is the implication for the optimal capital structure if there is a flat corporate tax rate? Explain your answer using an appropriate analytical expression.
B3. Debt policy (Answer all parts of this question.) (a) (4P) Assume that we have perfect and efficient capital markets, no taxes, and no asymmetric information. What are the two main theorems for i. capital structure and ii. cost of equity capital according to Modigilani-Miller? Give a brief answer. (b) Companies A and B differ only in their capital structure. Company A is financed 30 percent debt and 70 percent equity; Company B is financed 10 percent debt and 90 percent equity. The debt of both companies is risk free. Mr Miller owns 1 percent of the common stock of company A, (EA). Show that an investment in 1% of the common stock of company B (EB) and borrowing an amount equal to 1% of the difference in total debt of both companies, DA - DB i. (5P) costs the same, and ii. (5P) yields identical returns to his investment in 1% of the common stock of company A, (EA). Assume that the theorems of Modigilani-Miller hold. (c) (6P) In real life, firms are subject to corporate taxes. What is the implication for the optimal capital structure if there is a flat corporate tax rate? Explain your answer using an appropriate analytical expression.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:B3. Debt policy (Answer all parts of this question.)
(a) (4P) Assume that we have perfect and efficient capital markets, no taxes, and
no asymmetric information. What are the two main theorems for
i. capital structure and
ii. cost of equity capital
according to Modigilani-Miller? Give a brief answer.
(b) Companies A and B differ only in their capital structure. Company A is
financed 30 percent debt and 70 percent equity; Company B is financed 10
percent debt and 90 percent equity. The debt of both companies is risk free.
Mr Miller owns 1 percent of the common stock of company A, (EA). Show that
an investment in 1% of the common stock of company B (EB) and borrowing an
amount equal to 1% of the difference in total debt of both companies, DA - DB
i. (5P) costs the same, and
ii. (5P) yields identical returns
to his investment in 1% of the common stock of company A, (EA).
Assume that the theorems of Modigilani-Miller hold.
(c) (6P) In real life, firms are subject to corporate taxes. What is the implication
for the optimal capital structure if there is a flat corporate tax rate? Explain
your answer using an appropriate analytical expression.
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