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1) This problem concerns some extensions of M-M theory. M-M theorem supposes that firm has only 2 classes of securities, perpetual debt and equity. Assume that firm has issued a 3rd class of securities – preferred stock – and that y% of favoured dividends may be written off as the expense (0≤y≤1). Suppose that firm has favoured stock of face value FP, with a favoured dividend rate of rp. Favoured dividends and debt are riskless (use the risk free rate, rf). Suppose that only corporate tax, τC, exists. No personal taxes. Also other suppositions of M-M hold. Rate of return of the unlevered company in risk-class k is ρU.

a) Determine the suitable expression for value of levered firm?

b) Compute the suitable expression for after-tax cost of capital, ρτL?

This problem concerns M-M proposition I (irrelevance of capital structure). Imagine of 2 firms, similar in every way apart from in their capital structure: first is financed by= 100% equity (unlevered), whereas other is financed part by equity and part by riskless debt (levered). Suppose that CAPM suppositions hold, but that these firms have no systematic risks (beta = 0). Also other M-M- I suppositions hold: no market imperfections of any kind. Let distribution of their operating income per year be as follows (suppose perpetual cash flows).

    Y            Probability
1,500,000    0.5
1,100,000    0.5

Basic Finance, Finance

  • Category:- Basic Finance
  • Reference No.:- M914816

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