1 Let the crossover EBIT be x

Issuing Equity Issuing Debt

EBIT x x
Less: Interest Expense 50 71
Less: Taxes = PAT (x-50)(1-.34) (x-71)(1-.34)
EPS (x-50)(1-.34)/95…....(i) (x-71)(1-.34)/80…....(ii)
Solving (i) and (ii), we get x as $183m

2 Ms Kraft owns $100,000/$16,000,000=0.00625 of Copperhead’s equity

To receive exactly the same profits as before, she has to:
a. Borrow 0.00625 x $1m = $6,250 and
b. Buy $6,250 (= 3,125 shares at $2) of more commonstock of Copperhead to maintain the equitypercentage at $

3 Rs = Ro + B/S (Ro - Rb)

Ro = 50/80*16%+30/80*8% 0.13
Rs = .13 + 20/60(.13- 0.08) 14.67%

4 a. True. MM Propositions have few assumptions and among them one of them says that there are no taxes and th
b. True. As long as the return earned by the company is greater than the interest payment, earnings per share incr
c. False. The cost of equity increases with the ratio D/E.
d. False. As the debt in the capital structure increases, the cost of borrowing will increase and so will the financia
e. False. Borrowing does increase the financial risk and cost of equity. Leverage in the capital structure magnifie
f. False. MM theory says that the borrowing does not affect the value of firm, however it says that the corporate b

5 I) The value of the both the firms is equal and each of their value is represented by V.
To purchase one percent of Company B's equity (0.009V) and the company borrows an amount equal to:
0.01 x (DA - DB) = 0.002 V
This investment requires a net cash outlay of (0.007 V) and it provides a net cash return of:
(0.01 x Profits) - (0.003 × rf × V)
Here rf is the risk-free rate of interest on debt. And therefore the two investments are identical.
II) In this case the company can buy two percent of company A's investment and lend an amount equal to:
0.02 x (DA DB) = 0.004 V
This investment requires a net cash outlay of (0.018 V) and provides a net cash return of:
(0.02 × Profits) – (0.002 × rf × V)
Therefore the two investments are identical.
III) The expected dollars return to company's original investment in A is:
(0.01 × C) (0.003 × rƒ × V₁)
Here C = Expected profit (cash flow) generated by the firm's assets.
As the firms are the same except for capital structure, C must also be the expected cash flow for Firm B.
The dollar return to company's alternative strategy is:
(0.01 x C) (0.003 × If × VB)
Also, the cost of the original strategy is (0.007VA) while the cost of the alternative strategy is (0.007VB)
In the event of the value of company A is less than the value of company B, the original strategy of investing in c
6 A. Stock price remains same , market price of stock not affected by the announcement.
Because Market price of stock affected by return on investments etc.
B. Market price of shares = $10 company can buy back the
160/10= 16 million
C. After the change in capital structure, the Market value of Firm is unchanged and is euqal to Equity + Debt
=(9 million × $10) + $160 =$250 million
Market value of debt = 250 +160= 410 million
Market value of Firm unchanged
D. Debt ratio = Debt /(debt +equity) = 160/250= 0.64
E. No gain or loses because market value of Firm and price unchanged.

7 a. Value of Equity = 550 Million

Value of Debt = 200 million
WACC 10.0133333333333
b. In this case the WACC would be same as cost of equity i.e. 12%. It would be higher by almost 2%

8 a. Relative Tax Advantage of Corporate Debt = (1-Tp)/((1-Tpe)(1-Tc)

= (1-0.35)/((1-0)*(1-0.39)) 1.0655737704918
b. Relative Tax Advantage of Corporate Debt = (1-Tp)/((1-Tpe)(1-Tc)
= (1-0.35)/((1-0.15)*(1-0.39)) 1.25361620057859
 n the equitypercentage at $106250/$17 million=0.00625

hat there are no taxes and there is symmetry of information.

ent, earnings per share increase, but the P Falls to reflect the higher risk.

ease and so will the financial distress cost. The cost of equity also increases as the debt level increases
e capital structure magnifies the return on equity. Profits and Losses will also be maginified
er it says that the corporate borrowing increases earning per share as long as rate of return is greater than the interest paid

an amount equal to:

an amount equal to:

sh flow for Firm B.

rategy is (0.007VB)
nal strategy of investing in company A results in not only less cost but also a larger dollar return. Therefore no rational investor w
 euqal to Equity + Debt

er by almost 2%
an the interest paid

efore no rational investor will be willing to invest in company B if its value is higher than the company A.