Comm298 Corporate Finance

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Practice for Lecture 5: Basic Capital Structure Question 1. Prove Modigliani-Miller proposition 1 with corporate taxes. As part of your answer, clearly state the underlying assumptions, explain the intuition underlying the proof, and conceptually interpret the meaning of the proposition. Note: you should be able to formally prove MM 1 & MM2 as we did in class. Question 2. Levered Inc. and Unlevered Inc. are identical in every respect except for capital structure. Both companies expect to earn $96 million in perpetuity, and both distribute all of their earnings as dividends. Levered’s perpetual debt has a market value of $275 million and the required return on its debt is 8%. Levered’s stock sells for $100 per share, and there are 4.5 million shares outstanding. Unlevered has 10 million shares outstanding worth $80 each. Unlevered has no debt. These firms operate in the Modigliani-Miller world with no taxes. How can you take advantage of this scenario? Question 3. Levered Inc. and Unlevered Inc. are identical in every respect except for capital structure. Both companies expect to earn $150 million in perpetuity, and both distribute all of their earnings as dividends. Levered’s perpetual debt has a market value of $300 million and the required return on its debt is 7%. Levered’s stock sells for $100 per share, and there are 5 million shares outstanding. Unlevered has 8 million shares outstanding worth $90 each. Unlevered has no debt. These firms operate in the Modigliani-Miller world with no taxes. How can you take advantage of this scenario? Question 4. Northrop has 80 million shares worth $10 per share and no debt. Its cost of capital is 5%. It has a perpetual random CF with mean $40 million and it pays no taxes. Northrop plans a leveraged recapitalization, in which it will issue $300 million in perpetual debt at an interest rate of 2% per year

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