Peirson12e SM CH12

Chapter 12
Principles of capital structure
Solutions to questions
1. The advantage of using debt is that it may increase the returns to the companys
shareholders. However, the disadvantage is that using debt increases the risk of an
investment in the companys shares (see Example 12.1). An increased use of debt is
justified where it results in an increase in shareholders wealththat is, the advantage of
the increase in returns outweighs the disadvantage of an increase in risk. The MM
analysis shows that any such increase in shareholders wealth can arise only from taxes
or imperfections such as agency costs.
2. Business risk is the risk inherent in a companys operations, and will depend largely on
the industries in which the company operates.
Financial risk is the additional risk to which shareholders are exposed due to a
companys use of debt finance.
Default risk is the risk that a borrower may fail to make the repayments that are due to
lenders.
Both financial risk and default risk are associated with debt finance, but the two risks can
be distinguished. In particular, any borrowing by a company will cause financial risk,
even if the risk that the borrower may default is zero.
3. (a) The MM propositions are as follows:

Proposition 1: The value of a company is independent of its capital structure.
(Changing a companys debtequity ratio will only change the way in which its net
cash flows are divided between debtholders and shareholders, but cannot change the
total value of the cash flows.)
Proposition 2: This is expressed by Equation 12.3 as follows:
D
ke k0 ( k0 k d )
E
That is, for a levered company, the cost of equity capital consists of:
(i) k0, which is the rate of return that investors require based on a companys
business risk;
Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton and Pinder 1 of 17
McGraw-Hill Education (Australia) 2015
CHAPTER 12
(ii) an increment for financial risk which is proportional to the companys debt
equity ratio and depends on the difference between k0 and kd.
Proposition 3: The appropriate discount rate for a particular investment proposal is

independent of how the proposal is to be financed. The appropriate discount rate
depends on the features of the investment proposal, in particular its riskiness.
The assumptions underlying MMs analysis of capital structure are as follows:

(i) securities issued by companies are traded in a perfect capital market, which is a
frictionless market in which there are no transaction costs and no barriers to the
free flow of information;
(ii) there are no taxes;
(iii) companies and individuals can borrow at the same interest rate; and
(iv) there are no costs associated with the liquidation of a company.
Violation of these assumptions will not necessarily invalidate the MM propositions.
(b) Proposition 1 states that the value of a company is independent of its capital
structurethat is, corporate borrowing will have no effect on shareholders wealth.
Proposition 2 shows that there is a positive relationship between a companys debt
equity ratio and the expected rate of return on its shares. The apparent contradiction
disappears when it is recognised that because of the financial risk associated with
borrowing, the shareholders required rate of return also increases. In fact, the
required rate of return will be exactly equal to the expected rate of return; therefore,
there is no effect on shareholders wealth.
4. This is shown by Example 12.3 in the chapter. By selling Ls securities and switching to
Us securities, there is trading in both debt securities and shares. Thus, it is not necessary
for arbitrage transactions to involve personal borrowing.
5. Miller suggests that where the effective (personal) tax rate on income derived from
holding debt exceeds that on income from holding shares, then any advantage from the
tax deductibility of interest payments at the company level will be reduced or totally
offset. The discussion of the Australian tax environment in Chapter 11 suggests that most
taxpayers do pay tax at a higher rate on income from debt than on income from shares. In
addition, there are some investors who pay no tax on income from financial assets
(charities, universities and other tax-exempt investors). It is this latter group that receives
most of the tax benefits associated with the use of debt by companies. Millers analysis
was appropriate to Australia under the classical tax system, because the effective tax rate
on income from debt was higher than that on income from shares. Under the imputation
tax system, Millers conclusion holds, but in this case, it results from the structure of the
tax system rather than from a competitive equilibrium. (Therefore, it is not correct to say
that his analysis applies under imputation.) In particular, the imputation system
highlights the need to consider the effects of taxes levied at both the company and
personal levels, since company tax is effectively a withholding tax, and all distributed
company income is taxed only at personal rates.
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6. It is true that Millers analysis assumes that a company can absorb fully the tax benefits
generated by the interest payments on debt in all future periods. There are two reasons
why this may not be true:
(a) earnings in some future periods may not be sufficient to absorb all tax deductions
generated during those periods; and
(b) the point made in (a) is reinforced when the tax deductions generated by competing
sources (for example, depreciation and research and development costs) are taken
into account.
7. Millers model suggests that the statement is true. For example, if the personal tax on
equity returns is zero, but interest on debt is taxed at the rate tp, then investors whose tp >
tc (where tc = company income tax rate) would prefer to invest only in shares, while
investors whose tp < tc would prefer to invest only in debt. This is one type of clientele
effect. There is some relatively weak evidence for the existence of investor clienteles
but, in practice, the market does not appear to be segmented as clearly as Millers model
suggests. (The tax system is also likely to cause a dividend-related clientele effect. For
example, the imputation system increases the incentive for resident investors to hold
shares in companies paying franked dividends.)
8. Bankruptcy costs are those costs associated with financial difficulty that leads to the
control of the company being transferred to lenders. It is argued that the market value of
a company will be reduced to the extent of the present value of the expected bankruptcy
costs, where the present value of the expected bankruptcy costs is positively related to
the probability of bankruptcy (financial distress) and to the costs incurred if the company
is in financial distress. The probability of financial distress increases with the total risk of
the company, and hence, with the companys debtequity ratio. Therefore, expected
bankruptcy costs are a negative feature of borrowing.
9. (a) The statement is not entirely correct. Interest on debt is taxed only once at the
debtholders marginal tax rate. Equity returns are taxed at the company level, but
shareholders receiving franked dividends receive a credit for the company tax paid.
This means that their returns can also be effectively taxed only once at the
shareholders marginal tax rate. Therefore, if all profits are distributed as franked
dividends, for investors in a given tax bracket, total tax paid will not be affected by
changing the companys debtequity ratio. However, for investors with personal tax
rates greater than the company tax rate, there can be an incentive to retain, rather
than distribute, profits. For these investors, the system is not neutral, but any bias
favours equity rather than debt.
(b) The statement is incorrect. When a company is liquidated, its equity is generally
worthless, so the liquidation costs incurred will be borne by lenders (debtholders).
However, debtholders realise this and, when they lend funds, will require
compensation, in the form of a higher interest rate, for these expected costs. Thus,
while realised liquidation costs are borne by debtholders, expected liquidation costs
will be borne by shareholders. Similarly, it can be argued that agency costs of debt
will be passed on to shareholders.
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(c) It is true that empirical studies suggest that direct bankruptcy costs are small relative
to the value of assets. When allowance is made for the probability of failure,
expected direct bankruptcy costs are even smaller. However, as discussed in the
chapter, there is empirical evidence which indicates that indirect bankruptcy costs
are much larger than the direct costs.
10. It is shown in the chapter that management can make decisions that lead to wealth
transfers from debtholders to shareholders. For example, the claim held by existing
debtholders may be diluted by issuing additional debt. The incentive to make such
decisions is greatest when a company has a high debtequity ratio. Debtholders aim to
prevent these wealth transfers by including restrictive covenants in loan agreements.
11. Agency costs are inherent in relationships where one party (the principal) delegates
decision-making authority to another (the agent). Agency costs include losses borne by
the principal, because the agent will maximise his own welfare rather than acting solely
in the interests of the principal. They also include the cost of monitoring the agent to
ensure that he does not depart too far from serving the principals interests. Agency costs
are relevant to capital structure decisions because equity and debt both involve agency
costs. For example, employee managers may not maximise shareholders wealth, giving
rise to a need for monitoring by shareholders. Similarly, the agency costs of debt include
the costs of negotiating loan agreements which limit the possibility of wealth transfers
from debtholders to shareholders, and the costs of monitoring the company to ensure that
these agreements are not breached. Monitoring by debtholders may reduce the need for
monitoring by shareholders. Therefore, there may be an optimal debtequity ratio which
maximises shareholders wealth by minimising total agency costs.
12. (a) Superficially, debt appears to be cheaper than equitythat is, kd < ke. However, the
interest cost of debt is only its explicit cost. Borrowing creates financial risk which
causes the cost of equity capital to increase. This increase in the cost of equity is an
implicit cost of debt and MM show that in a perfect capital market, the true cost of
all forms of finance is the same. The fact that companies are allowed a tax deduction
for interest would give debt an advantage if income to investors in both debt and
equity were taxed at the same rate. However, Miller points out that, generally,
personal tax on debt is greater than that on equity. He argued that this differential
could exactly offset the tax deductibility of interest. In Australia, the imputation tax
system is also relevant (see Question 11(a)).
(b) The statement reflects the traditional view of capital structure and confusion
between two separate risks. The first sentence is basically true, but the second
sentence does not follow from the first. While the risk of financial distress may be
negligible, any borrowing creates financial risk, and the MM analysis shows that
shareholders will require compensation for that riskthat is, the cost of equity will
increase as shown by their Proposition 2.
13. Possible reasons include:
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i. Transaction costs. Issuing new shares can involve high costs. For
example, a rights issue requires the company to contact every shareholder and
process many payments.
ii. Information asymmetry. If managers believe that the shares are overvalued,
they have an incentive to issue new shares. But investors understand this
incentive and will interpret a new share issue as evidence that the shares are
overvalued. Therefore, the share price falls. Hence, managers will avoid
making new share issues.
Solutions to problems
1. (a) Note: The original entries are shown in bold.
Capital structure (i) Capital structure (ii) Capital structure (iii)

Assets $50m $50m $50m $50m $50m $50m $50m $50m $50m
Debt/Assets 0% 0% 0% 20% 20% 20% 50% 50% 50%
Debt ($) $0 $0 $0 $10m $10m $10m $25m $25m $25m
Equity ($) $50m $50m $50m $40m $40m $40m $25m $25m $25m
EBIT ($) $2.5m $5m $10m $2.5m $5m $10m $2.5m $5m $10m
Interest ($) $0 $0 $0 $1m $1m $1m $2.5m $2.5m $2.5m
Net income $2.5m $5m $10m $1.5m $4m $9m $0 $2.5m $7.5m
($)
RoA (%) (a) 5% 10% 20% 5% 10% 20% 5% 10% 20%
RoE (%) (b) 5% 10% 20% 3.75% 10% 22.5% 0% 10% 30%
(a) RoA (Return on Assets) = EBIT / Assets

(b) RoE (Return on Equity) = Net income / Equity
In each column, the calculations are:

Assets = $50m (given)
Debt/Assets = 0%, 20% or 50% (given)
Debt = (Debt / Assets) Assets
Equity = Assets Debt
EBIT = $2.5m, $5m or $10m (given)
Interest = Interest rate (given as 10%) Debt
Net income = EBIT Interest
RoA = EBIT / Assets
RoE = Net income / Equity
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(b)
RoE%
30% Capital Structure (iii)
25% Capital Structure (ii)
20% Capital Structure (i)
15%
10%
5%
5% 10% 15% 20% RoA%
Comments:
1. The more debt, the greater the variability of returns to shareholders. In capital
structure (iii), debt turns good years (RoA = 20%) into great years for shareholders
(RoE = 30%), but also turns bad years (RoA = 5%) into very bad years for
shareholders (RoE = 0%).
2. If RoA equals the interest rate, then RoE = RoA. Therefore, debt advantages
shareholders if RoA is greater than the interest rate but debt disadvantages
shareholders if RoA is less than the interest rate.
2. (a) (i) All equity:

$150 000
Rate of return = 100
$1 000 000
= 15 per cent per annum
(ii) 50 per cent equity:
Interest on debt = $500 000 0.12
= $60 000 per annum
$150 000 $60 000

Rate of return to shareholders = 100
$500 000
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(iii) 25 per cent equity:
Interest on debt = $750 000 0.12
= $90 000 per annum
$150 000 $90 000

Rate of return to shareholders = 100
$250 000
(b) The calculations in (a) illustrate the effect of financial leverage: provided that the
rate of return on assets exceeds the rate of interest on debt, increasing the debt
equity ratio increases the rate of return that shareholders can expect. However,
leverage also causes financial risk and will magnify the effect of any increase or
decrease in the earnings stream. For example, if the earnings stream decreased to
$100 000 per annum, the results in (a) would become:
(i) 10 per cent per annum
(ii) 8 per cent per annum
(iii) 4 per cent per annum
3. (a) Market value per share of Rockmelon Pty Ltd:

$6 000 000
6 000 000
= $1 per share
Therefore, the current market value of Chee Wengs shares is:

$1 600 000
= $600 000
Chee Wengs dollar return from Rockmelon Pty Ltd is as follows:

$1 500 000 ($4 000 000 0.08)
600 000
6 000 000
= $118 000 per annum
(b) Chee Weng can obtain the same dollar return with a lower net cost by replicating the
debtequity ratio adopted by Rockmelon Pty Ltdthat is, by investing in
Cantaloupe Pty Ltd with his own resources and borrowed funds (assuming that Chee
Weng can also borrow at 8 per cent).
Let the borrowed sum = D
Own funds = E
Portfolio value V = D+E
Debtequity ratio
E 3
=
D 2
E = 1.5D
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Annual income before interest
D+E
1 500 000
8 000 000
= 0.1875 (D + E)
Net annual income
0.1875 (D + E) 0.08D
which must be the same as $118 000 (the dollar return from Rockmelon shares).
$118 000 = 0.1875 (D + E) 0.08D
$118 000 = 0.1875 (D + 1.5D) 0.08D
$118 000 = 0.388 75D
D = $303 537
E = $303 537 1.5
= $455 305
V = $303 537 + $455 305
= $758 842
Therefore, by borrowing $303 537 and investing this amount together with his own
contribution of $455 305 in Cantaloupe shares, Chee Weng can receive the same
income of $118 000 per annum. The net outlay of $455 305 is therefore less than the
investment in Rockmelon ($600 000).
4. (a) The market value of Harolds investment in Lancelot is 200 000 $0.59 = $118 000.
The net income available to shareholders in Lancelot is:
Net operating cash flow $500 000
less Interest expense (0.09 $2m) $180 000
equals Net income available to shareholders $320 000
Harold owns 200 000 of the 3 200 000 shares and hence is entitled to a return of:
200 000
$320 000 $20 000
3 200 000
Harolds risk is measured by the debtequity ratio of Lancelot, which is:
$2 000 000 $2 000 000
1.059322
3 200 000 $0.59 $1 888 000
(b) (i) Harold sells the Lancelot shares and borrows $125 000.
Harold sells the Lancelot shares for $118 000.
He then borrows $125 000 and invests the whole proceeds of $118 000 + $125 000 =
$243 000 in Universal shares.
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The proportion of Universal that Harold owns is:
$243 000 $243 000
0.066122448
$1 500 000 $2.45 $3 675 000
He is therefore entitled to a gross return of:
0.066122448 $500 000 = $33 061
But Harold must pay interest of 0.09 $125 000 = $11 250, which gives him a net
return of:
$33 061 $11 250 = $21 811
Harolds debt-equity ratio is:
$125000
1.059322
$118000
Harolds net return ($21 811) is greater than it was before ($20 000).
His risk (1.059322) is the same as it was before.
Hence, Harold has achieved an arbitrage.
(ii) Harold sells the Lancelot shares and borrows $85 672.
He then borrows $85 672 and invests the whole proceeds of $118 000 + $85 672 =
$203 672 in Universal shares.
$203 672
0.055420952
$3 675 000
0.055420952 $500 000 = $27 710
But Harold must pay interest of 0.09 $85 672 = $7710, which gives him a net return
of:
$27 710 $7710 = $20 000
Harolds debtequity ratio is:
$85672
0.726034
$118000
Harolds net return ($20 000) is equal to his previous return.
His risk (0.726034) is less than it was before (1.056022).
(iii) Harold sells the Lancelot shares, spends $9798 and then borrows $114 619
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He then spends $9798, leaving $118 000 $9798 = $108 202.
He then borrows $114 619 and invests $108 202 + $114 619 = $222 821 in Universal
shares.
$222 821
0.060631565
$3 675 000
0.0060631565 $500 000 = $30 316.
But Harold must pay interest of 0.09 $114 619 = $10 316, which gives him a net
return of $30 316 $10 316 = $20 000.
Harolds debt-equity ratio is:
$114 619
1.059306
$108 202
Harolds net return ($20 000) is equal to his previous return.
His risk (1.059306) is slightly less than it was before (1.059322).
But Harold also has $9798 to spend.
5. (a) The market value of Jessicas investment in Levity is 10 000 $20.48 = $204 800.
The net income available to shareholders in Levity is:
Net operating cash flow $10 00 000
less Interest expense (0.075 $30m) $2 250 000
equals Net income available to shareholders $7 750 000
Jessica owns 10 000 of the 1 250 000 shares and hence is entitled to a return of:
10 000
$7 750 000 $62 000
1 250 000
Jessicas risk is measured by the debt-equity ratio of Levity, which is:
$30 000 000 $30 000 000
1.171875
1 250 000 $20.48 $25 600 000
(b) (i) Jessica sells the Levity shares and borrows $240 000.
Jessica sells the Levity shares for $204 800.
She then borrows $240 000 and invests the whole proceeds of $204 800 + $240 000 =
$444 800 in Unicorn shares.
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The proportion of Unicorn that Jessica owns is:
$444 800 $444 800
0.008553846154
$40 000 000 $1.30 $52 000 000
She is therefore entitled to a gross return of:
0.008553846154 $10 000 000 = $85 538.
But Jessica must pay interest of 0.075 $240 000 = $18 000, which gives her a net
return of $85 538 $18 000 = $67 538.
Jessicas debt-equity ratio is:
$240 000
1.171875
$204800
Jessicas net return ($67 538) is greater than it was before ($62 000).
Her risk (1.171875) is the same as it was before.
Hence, Jessica has achieved an arbitrage.
(ii) Jessica sells the Levity shares and borrows $192 787
She then borrows $192 787 and invests the whole proceeds of $204 800 + $192 787 =
$397 587 in Unicorn shares.
$397 587
0.007645903846
$52 000 000
0.007645903846 $10 000 000 = $76 459.
return of $76 459 $14 459 = $62 000.
$192 787
0.941343
$204 800
Jessicas net return ($62 000) is equal to her previous return.
Her risk (0.941343) is less than it was before (1.171875).
Hence, Jessica has achieved an arbitrage.
(c) Jessica should first sell the Levity shares for $204 800. She then retains cash of $R,
leaving her with $204 800 $R of her own money to invest. She then borrows $B
and invests the sum of $204 800 $R + $B in Unicorn shares. The problem is to
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choose R and B such that Jessicas net return is the same as originally ($62 000) and
her risk (1.171875) is also the same as originally.
Jessicas gross return is given by:
$204 800 $ R $ B
Gross return $10 000 000
$52 000 000
Interest expense 0.075 $ B
$204 800 $ R $ B
Hence, net return = $10 000 000 0.075 $ B
$52 000 000
Therefore one equation to be solved is:
$204 800 $ R $ B
$10 000 000 0.075 $ B $62 000 (eqn 1)
$52 000 000
Jessicas risk is given by the ratio of her debt ($B) to her equity ($204 800 $R) and
this must be the same as originally (1.171875).
Hence another equation to be solved is:
$B
1.171875 (eqn 2)
$204 800 $ R
These two equations must be solved simultaneously. This is a purely mathematical
problem, the solutions to which are (to the nearest dollar):
$R = $16 795 and
$B = $220 319.
It can be shown as follows that these are indeed the correct solutions.
She then spends $16 795, leaving $204 800 $16 795 = $188 005.
She then borrows $220 319 and invests $188 005 + $220 319 = $408 324 in Unicorn
shares.
$408 324
0.007852384615.
$52 000 000
0.007852384615 $10 000 000 = $78 524.
return of $78 524 $16 524 = $62 000.
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$220 319
1.171878
$188 005
Jessicas net return ($62 000) is equal to her previous return.
Except for a small rounding error, her risk (1.171878) is the same as it was originally
(1.171875).
But Jessica also has $16 795 to spend.
6. Sell the Cockatiel shares for $10 000. The debtequity ratio of Cockatiel is 59.3 per cent.
Therefore, Jane should borrow $5 930 at 8 per cent per annum and buy $15 930 of
Quarrion shares.
$
Janes income from investment in Quarrion shares: 2 230
Janes income from investment in Cockatiel shares: 1 600
Increase in Janes income: 630
less Interest at 8% 474
Net increase in Janes income: $ 156
7. Sell the Parramatta Pet Food shares for $666.67. The debtequity ratio of Parramatta Pet
Food is 75 per cent. Therefore, I should borrow $500 at 4 per cent per annum and buy
$1 166.67 of Penrith Pet Food shares.
$
Income from investment in Penrith Pet Food: 116.67
Income from investment in Parramatta Pet Food: 80.00
Increase in income: 36.67
less Interest at 4% 20.00
Net increase in income: $ 16.67
8. The question implicitly assumes that earnings before interest (X) remains constant in
perpetuity.
X (1 tc )
All equity VU =
k0
$600 000 (1 0.30)
=
0.15
= $2 800 000
Equity and 10% loan V = VU + tc(D)

= 2 800 000 + 0.30(1 500 000)
= $3 250 000
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9. ConsiderthefourscenariosshowninTable12.8.
AlternativeinformationandfinancingscenariosforSophiePharmaceuticalsLtd
Financingmethod
Timethattheinvestmentismade
Newshareissue Newdebtissue
Beforethesharemarketlearnsthe
Scenario1 Scenario3
truevalueoftheexistingassets
After the share market learns the
Scenario2 Scenario4
truevalueoftheexistingassets
Thecurrentmarketvalueofthesharesonissueis9.6million$12.50=$120m.
Thetruevalueofthesharesonissueis9.6m$13.00=$124.8m.
Scenario1
Initially,thesharepriceis$12.50,sothenumberofnewsharestobeissuedis$15m/$12.50=
1.2m,bringingthetotalnumberofsharesonissueto9.6m+1.2m=10.8m.Afterthenew
investmentisannounced,andthenewsharesareissued,thesharepriceintheshorttermwill
be:
$120m $15m $2.5m

PS $12.73
10.8m
Hadthenewinvestmentnotbeenmade,thesharepricewouldhaveremainedat$12.50,so
boththeoldandnewshareholdersgain23centspershare.
Inthelongterm,thesharemarketlearnsthetruevalueoftheexistingassets,andtheshare
pricewillbe:
$124.8m $15m $2.5m

PL $13.18
10.8m
Therefore,inthelongterm,thenewshareholdersgain68centspershare.Buthadthenew
investmentnotbeenmade,thesharepricewouldhavebeen$13.00,sotheoldshareholders
gainonly18centspershare,comparedtowhattheywouldotherwisehavehad.
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Scenario2
Intheshortterm,thesharepriceremainsat$12.50.Inthelongterm,thesharemarketlearns
thetruevalueoftheexistingassetsandthesharepriceincreasesfrom$12.50to$13.00.
Therefore,thenumberofnewsharestobeissuedis$15m/$13.00=1153846,bringingthe
total number of shares on issue to 9600000 + 1153846 = 10753846. After the new
investmentisannounced,andthenewsharesareissued,thesharepricewillbe:
$124.8m $15m $2.5m

PL $13.23
10 753 846
Inthisscenario,boththenewshareholdersandtheoldshareholdersgainby23centsper
share.
Scenario3
Ifthecompanyborrowstofinancetheproject,allthebenefitofthepositivenetpresentvalue
willgotothecurrentshareholders.Afterthenewinvestmentisannounced,andthenewdebt
isissued,thesharepricewillbe:
$120m $2.5m
PS $12.76
9.6m
Intheshorttermtheshareholdersgainby26centspershare.Inthelongterm,theshare
marketlearnsthetruevalueoftheexistingassets,andthesharepricewillbe:
$124.8m $2.5m
PL $13.26
9.6m
Hadthenewinvestmentnotbeenmade,thesharepricewouldhavebeen$13.00,sointhe
longtermtheshareholdersgainby26centspershare.
Scenario4
Intheshortterm,thesharepriceremainsat$12.50.Inthelongterm,thesharemarketlearns
thetruevalueoftheexistingassetsandthesharepriceincreasesfrom$12.50to$13.00.After
thenewinvestmentisannounced,andthenewdebtisissued,thesharepricewillbe:
$124.8m $2.5m
PL $13.26
9.6m
Inthelongtermtheshareholdersgainby26centspershare.
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Insummary,withoutthenewinvestment,theshorttermoutcomeisasharepriceof$12.50
whilethelongtermoutcomeisasharepriceof$13.00.Withthenewinvestment,theshort
termandlongtermoutcomesarethoseshowninthetablebelow.
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Share price outcomes of alternative information and financing scenarios for Sophie
PharmaceuticalsLtd
Timethattheinvestment Financingmethod
ismade Newshareissue Newdebtissue
Scenario1 Scenario3
Beforethesharemarket Sharepriceintheshort Sharepriceintheshort
learnsthetruevalueofthe term:$12.73 term:$12.76
existingassets Sharepriceinthelong Sharepriceinthelongterm:
term:$13.18 $13.26
Scenario2 Scenario4
Afterthesharemarket Sharepriceintheshort Sharepriceintheshort
learnsthetruevalueofthe term:$12.50 term:$12.50
existingassets Sharepriceinthelong Sharepriceinthelongterm:
term:$13.23 $13.26
Comparingthefourscenarios,theclearwinnerisScenario3,inwhichthenewinvestment
projectshouldbeacceptedimmediately,andshouldbefinancedbydebt.Scenario3produces
thehighestsharepriceintheshorttermandtheequalhighestsharepriceinthelongterm.
TheworstoutcomeinthelongtermisclearlyScenario1,inwhichthenewinvestmentis
undertakenimmediately,andisfinancedbyshares.

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Chapter 12

Principles of capital structure

3. (a) The MM propositions are as follows:

Proposition 3: The appropriate discount rate for a particular investment proposal is

The assumptions underlying MMs analysis of capital structure are as follows:

Violation of these assumptions will not necessarily invalidate the MM propositions.

13. Possible reasons include:

1. (a) Note: The original entries are shown in bold.

Capital structure (i) Capital structure (ii) Capital structure (iii)

(a) RoA (Return on Assets) = EBIT / Assets

In each column, the calculations are:

30% Capital Structure (iii)

25% Capital Structure (ii)

20% Capital Structure (i)

5% 10% 15% 20% RoA%

2. (a) (i) All equity:

$150 000 $60 000

$150 000 $90 000

3. (a) Market value per share of Rockmelon Pty Ltd:

Therefore, the current market value of Chee Wengs shares is:

Chee Wengs dollar return from Rockmelon Pty Ltd is as follows:

Equity and 10% loan V = VU + tc(D)

$120m $15m $2.5m

$124.8m $15m $2.5m

$124.8m $15m $2.5m

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