Question 2

(a) Critically explain the Modigliani and Millers (MM) proposition that capital structure does

not affect the value of a firm, highlighting the assumptions required for this proposition

to hold true. Use a numerical example to demonstrate and explain why there should be

no difference between home-made gearing and corporate gearing.

(40 marks)

(b) Explain what is meant by the pecking-order theory and how it relates to the observed

capital structures of a company.

(20 marks)

(c) Show clearly the impact of personal taxes on the firm value in a Modigliani and Miller

universe. When would a firm be indifferent between issuing debt or equity?

(20 marks)

(d) Alpha NV and Beta NV are identical in every way except their capital structures. Alpha

NPV, an all-equity financed firm, has 5,000 shares of equity outstanding, currently worth

20 per share. Beta NV uses leverage in its capital structure. The market value of Beta

NVs debt is 25,000, and its cost of debt is 12%. Each firm is expected to have earnings

before interest of 35,000 in perpetuity. Neither firm pays taxes. Assume that the capital

market is perfect and every investor can borrow at 12% per year.

REQUIRED:

(i) What is the value of Alpha NV? What is the value of Beta NV? What is the market

value of Beta NVs equity?

(15 marks)

(ii) Is Alpha NVs equity more or less risky than Beta NVs equity? Explain.

(5 marks)