M&M assumption

1. If the only violation of the M&M assumptions is that investors face one tax rate for interest income and another tax rate for equity income, what is the implication for the optimal capital structure of a corporation?

2. A corporation has the following balance sheet (liabilities side)

Current liabilities 2,000

Long-term debt   5,000

Preferred stock   2,000

common stock    8,000

retained earnings  3,000

Currently, the riskless interest rate is 8%; the corporate tax rate is 50%; the current price of a share of common stock is $20; and dividends have been level at $1 per share per year for many years.

Recently, company executives have considered expanding the existing business by acquiring a competitor. To do so, they must caluculate the WACC of the firm and estimate the NPV of the acquisition.  Because the acquisition is of the same risk as the firm, the WACC (unlevered equity cost) can be used.  

A financial executive has used the following procedure to calculate the WACC.  Debt and preferred cost are fixed claims offering a fairly secure constant return, and so their before tax cost is assumed to equal the riskless rate.  The dividend yield has held constant at about 5%; so this is used as the cost of new and retained equity (common plus reatined), and 10% current liabilities. Current liabilities are assumed to be costless; therefore the WACC is 4.55%.

Comment of this procedure:

3. A large food processor and distributor is considering expansion into a chain of privately owned sports shoe outlets. The food company wishes to estimate the risky discount rate for such investments so as to negotiate a fair price for the acquisition. Unfortunately, there are no stock exchange- listed sports shoe companies with a price history with which a %u201C sports shoe outlet beta%u201D can be estimated. However, executives are considering using the price history of another company to estimate the beta. Which of the following companies would be the most appropriate? Explain.
1. another large food company.
2. A holding company for a football team.
3. A company that manufactures shoes.
4. A chain of swimwear and surfboard stores in California.


A corporation’s securities have the following betas and market values:

                                       Beta                           Market Value

debt                              0.1                                100,000

preferred                       0.4                                200,000

common                       1.5                                 100,000

Calculate the following figures given a riskless interest rate of 10% and market risk premium of 5%

a. discount rates for each security

b. the asset beta for the coporation

c. the weighted average cost of capital

d. the discount rate for the unlevered assets

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