Extended Assumptions

(1)Debt interest tax deductible

-Common Stock, Preferred Stock -cost more
-Debt more - Value high
(2) MM Assumptions do not hold in real world
i) Debt/Assets Ratio increase - Interest Increase
ii) Expected tax rates fall at high debt level
iii) Bankruptcy cost probability law charges

Signaling theory
Symmetric Information
MM assume that investors have the same
information about a firms prospects as managers.

Asymmetric Information
The situation in which managers have different
(better) information about the firm.

Signal
The announcement of a stock offering by a mature
firm that have multiple financing alternative is
taken as a signal.

Reserve borrowing capacity

The ability to borrow money at a reasonable cost
when good investment opportunities arises, firms
often use less debt than specified by the MM
optimal capital structure to ensure that they can
obtain debt capital later if they need to.

Given the following information, calculate (i) the Earnings

Per Share (EPS) and (ii) Expected Earnings Per Share (iii)
Degree of Operating Leverage (DOL) (iv) Degree of
Financial Leverage (DFL) of ABC Company for 2002 if :
(i)Debt / Assets = 0%, (ii) Debt / Assets = 50%

Probability of Indicated sales

0.2
0.6
0.2
Sales (thousand)
Fixed Cost (thousand
Variable Cost (thousand
Total Cost (Except Interest)

EBIT

$ 200 $400
$600
(80) (80)
(80)
(120) (240) (360)
(200) (320 ) (440)
00

80

160

Assume the following:

(i)The firm is in the 40 percent tax bracket

(ii)Cost of debt is 12 percent
(iii)The value per share of ABC Company is $ 20
(iv)Total Capital of ABC Company is $ 200000