Corporate Finance

Corporate Finance, Assignment II

Problem 1

a) “If corporate debt is exposed to market risk, Modigliani-Miller’s proposition I will not hold.”

FALSE MM1 states that the firm’s value is independent of its capital structure. MM1 doesn’t say anything about the riskiness of the debt. When the firm’s capital structure becomes more levered, the riskiness of the firm increases, but the firm value is unchanged. MM1 holds.

b) “Because both bondholders and stockholders demand higher rates of return on more highly leveraged firms, a company that uses less financial leverage can reduce both its cost of debt and its cost of equity. Therefore, reducing a company’s debt ratio is an easy way to boost its value.”

FALSE Investors can lever their portfolio by taking debt and investing it further on. The investors are not willing to pay for something that they can do for themselves. That is why leveraging or reducing a company’s debt ratio does not affect the firm’s value.

Problem 2

- Identical assets

 Nano Industry Co. has 10 million shares outstanding €15 / share, which means that the market value and the equity is MEUR 150 (the company is all-equity firm).

a) Because the assets are equal, therefore

MEUR 150 = (20 million shares x P) + MEUR 50, where P = price / Geno´s stock

P = €5, so the equity of the Geno Technology Inc. is €5 x 20 million shares = MEUR 100.

b) Assuming the investor has no money to start with, the investor should short sell Nano industry stock to get €15 per share. Use this money to buy the underpriced Geno stock.