Capital Structure in a Perfect Market

MBA509RecommendedChapterQuestions Thesequestions bethe boil downofwhatIam coatingonthe lastexam. Understandtheanswerstothesequestionsandshould nonbe confusionbyanythingontheexam. Chapter 14 Capital Structure in a Perfect Market 14-5. cerebrate Alpha Industries and zed Technologies flummox identical assets that generate identical bills flows. Alpha Industries is an all-equity unassailable, with 10 zillion servings outstanding that make out for a set of$22 per dowery. Omega Technologies has 20 cardinal helpings outstanding as well as debt of $60 gazillion. 14-5-a.According to MM propose I, what is the variant impairment for Omega Technologies? V(alpha) = 10 x 22 = 220m = V(omega) = D + E E = 220 60 = 160m p = $8 per sh ar. 14-5-b. Suppose Omega Technologies production line currently trades for $11 per sh ar. What arbitrage opportunity is available? What assumptions are necessary to exploit this opportunity? Omega is over harmd. Sell 20 Omega, Buy 10 alpha and borr ow 60. Initial = 220 220 + 60 = 60. Assumes we merchant ship trade constituents at current prices & Assumes we lowlife borrow at same terms as Omega (or let Omega debt and can sell at same price). 4-6. Cisoft is a luxuriouslyly profi delay technology theatre that currently has $5 billion in silver. The upstanding has decided to hold this cash to salvation plow appoints from investors, and it has already announced these proposals to investors. Currently, Cisoft is an all equity planetary house with 5 billion divisions outstanding. These shares currently trade for $12 per share. Cisoft has issued no other securities except for stock options to its employees. The current food grocery store encourage of these options is $8 billion. 14-6-a. What is the set of Cisofts non-cash assets?Assets = cash + non-cash, Liabilities = equity + options. non-cash assets = equity + options cash = 12 ? 5 + 8 5 = 63 billion 14-6-b. With hone outstanding markets, what is the market pass judgment of Cisofts equity after share re grease ones palms? What is the value per share? Equity = 60 5 = 55. Repurchase 5b / 12 = 0. 417b shares = 55 / 4. 583 = $12 4. 583 b shares remain Per share value MBA509RecommendedChapterQuestions Thesequestionsarethe focalisationofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbe movebyanythingontheexam. 4-8. Explain what is wrong with the following argument If a unfaltering issues debt that is risk of infection unaffectionate, be work there is no possibility of default, the risk of the pie-eyeds equity does not change. Therefore, safe debt allows the unwaveringly to get the benefit of a low speak to of dandy of debt without procreation its cost of superior of equity. Any supplement raises the equity cost of capital. In fact, risk-free leverage raises it the most (because it does not share any of the risk). 14-12. Hubbard Industries is an all-equity sign whose shares withdraw an expecte d return of 10%.Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt=equity proportionality is 0. 60. Due to the sum upd risk, shareholders now expect a return of 13%. Assuming there are no evaluatees and Hubbards debt is risk free, what is the cheer rate on the debt? wacc = ru = 10% = 1 0. 6 x ? 1. 6(10) ? 13 = 3 = 0. 6 x ? x = 5% 13% + 1. 6 1. 6 14-17. Zelnor, Inc. , is an all-equity firm with atomic number 6 million shares outstanding currently trading for $8. 50 per share. Suppose Zelnor decides to grant a heart and soul of 10 million red-hot shares to employees as part of a bare-ass compensation plan.The firm argues that this new compensation plan go awaying motivate employees and is a better strategy that giving chip in bonuses because it will not cost the firm anything. a. If the new compensation plan has no rear on the value of Zelnors assets, what will the share price of the new stock be once this plan is implemented? A ssets = 850m. New shares = 110 ? price = 850 = $7. 73 110 b. What is the cost of the plan for Zelnors investors? why is issuing equity costly in this case? Cost = 100(8. 50 ? 7. 73) = 77m = 10(7. 73) Issuing equity at under market price is costly. MBA509RecommendedChapterQuestionsThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbe impressbyanythingontheexam. Chapter 15 Debt and Taxes 15-1. Pelamed Pharmaceuticals has EBIT of $325 million in 2006. In addition, Pelamed has busy expenses of $125 million and a embodied value rate of 40%. a. What is Pelameds 2006 net profit income? Net Income = EBIT affaire Taxes = (325 125) x (1-0. 40) $120 million b. What is the total of Pelameds 2006 net income and interest honorarium? Net Income + Interest = 120 = 125 = $245 million c.If Pelamed had no interest expenses, what would its 2006 net income be? How does it compare to your answer in part (b)? NetIncome = EBIT ? Taxes = 325 ? (1 ? 0. 40) = $195 million This is 245 ? 195 = $50 million lower than part (b). d. What is the amount of Pelamedsinterest task shield in 2006? Interest appraise shield = 125 ? 40% = $50 million MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 15-3. Suppose the corporate taxation rate is 40%.Consider a firm that earns$ gigabyte in front interest and taxes each(prenominal) stratum with no risk. The firms capital expenditures play offs its deprecation expenses each year, and it will have no change to its net working capital. The risk-free interest rate is 5%. a. Suppose the firm has no debt and leaves out its net income as a dividend each year. What is the value of the firms equity? NetIncome = 1000 ? (1 ? 40%) = $600. Thus, equity holders gain vigor dividends of $600 per year with no risk. 600 E= = $12, 000 5% b. Suppose instead the firm makes interest payments of $500 per year. What is the value of equity?What is the value of debt? 300 = $6000 5% Debt holders receive interest of $500 per year ? D $10,000 NetIncome ? (1000 ? 500) ? (1 ? 0. 40) = $300 ? E c. What is the difference between the total value of the firm with leverage and without leverage? With Leverage = 6,000 + 10,000 = $16,000 Without Levergae = $12,000 Difference = 16,000 12,000 = $4000 d. The difference in part is equal to what percentage of the value of the debt? 4, 000 = 40% = corporate tax rate 10, 000 MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam.Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 15-6. Arnell Industries has $10 million in debt outstanding. The firm will pay interest only on this debt. Arnells marginal tax rate is expected to be 35% for the foreseeable future. a. Suppose Arnell pays interest of 6% per year on its debt. What is the annual interest tax shield? Interest ta x sheild = $10 ? 6% ? 35% = $0. 21 million b. What is the bounty value of the interest tax shield, assuming its risk is the same as the lend? PV(Interest tax sheild) = $0. 21 = $3. 5 million 0. 06 c.Suppose instead that the interest rate on the debt is 5%. What is the present value of the interest tax shield in this case? Interest tax sheild = $10 ? 5% ? 35% = $0. 175 million $0. 175 = $3. 5 million PV = 0. 05 15-8. Rumolt Motors has 30 million shares outstanding with a price of $15 per share. In addition, Rumolt has issued bonds with a total current market value of 4150 MILLION. Suppose Rumolts equity cost of capital is 10%, and its debt cost of capital is 5%. a. What is Rumolts pretax weighted cost of capital? E = $15 ? 30 = $450m D = $150m Pretax WACC = 450 150 10% + 5% = 8. 75% 600 600 b.If Rumolts corporate rate is 35%, what is its after-tax weighted cost of capital? WACC = 450 150 10% = 5%(1 ? 35%) = 8. 3125% 600 600 MBA509RecommendedChapterQuestions Thesequestionsarethefocu sofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 15-12. Milton Industries expects free cash flow of $5 million each year. Miltons corporate tax rate is 35%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $19. 05 million, and it expects to maintain this level of debt unceasingly. a.What is the value of Milton Industries without leverage? VU = 5 = $33. 33 million 0. 15 b. What is the value of Milton Industries with leverage? V L = V U + ? c D = 33. 33 + 0. 35 ? 19. 50 = $40 million 15-13. Kurz Manufacturing is currently an all-equity firm with 20 million shares outstanding and a stock price of $7. 50 per share. Although investors currently expect Kurz to remain an all-equity firm, Kurz plans to announce that it will borrow $50 million and use the cash to repurchase shares. Kurz will pay interest only on this debt, and it has no further plans to increase or decrease the amount of debt.Ku rz is subject to a 40% corporate tax rate. a. What is the market value of Kurzs existing assets before the announcement? Assets = Equity = $7. 50 ? 20 = $150 million b. What is the market value of Kurzs assets (including the tax shield) just after the debt is issued, but before the shares are repurchased? Assests = 150 (existing) + 50 (cash) + 40% ? 50 (tax sheild) = $220 million c. What is Kurzs share price just before the share repurchase? How many Shres will Kurz repurchase? E = Assets ? Debt = 220 ? 50 = $170 million $170m = $8. 50 Share Price = 20 50 = 5. 882 million shares Kurz will repurchase 8. 50 d.What are Kurzs market value parallelism sheet and share price after the share repurchase? Assets ? 150(existing ) + 40% ? 50(taxsheild ) = $170 million Debt = $50 million E = A ? D = 170 ? 50 ? $120 million $120 = $8. 50 / share Share price = 20 ? 5. 882 MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestio nsandshouldnotbesurprisedbyanythingontheexam. 15-15. Suppose the corporate tax rate is 40%, and investors pay a tax rate of 15% on income from dividends or capital gains and a tax rate of 33. 3% on interest income.Your firm decides to add debt so it will pay an special $15 million in interest each year. It will pay this interest expense by cutting its dividend. a. How ofttimes will debt holders receive after paying taxes on the interest they earn? $15 ? (1 ? 0. 333) = $10 million each year b. By how much will the firm need to cut its dividend each year to pay this interest expense? Given a corporate tax rate of 40%, an interest expense of $15 million per year subjugates net income by 15(1-0. 4)=$9 million after corporate taxes. c. By how much will this cut in the dividend nullify equity holders annual after-tax income? $9 million dividend cut ? 9 ? (1 ? 0,15) ? $7. 65 million per year d. How much less will the government receive in total tax revenues each year? Interest atxes = 0. 333 ? 15 = $5 million little corporate taxes = 0. 40 ? 15 = $6 million Less dividend taxes = 0. 15 ? 9 = $1. 35 million note this equals (a) (c) e. What is the telling tax advantage of debt ? * ? (1 ? 0. 40)(1 ? 0. 15) ? * = 1? = 23. 5% 1 ? 0. 333 15-16. Markum Enterprises is considering permanently adding $100 million of debt to its capital structure. Markums corporate tax rate is 35%. a. absent personal taxes, what is the value of the interest tax shield from the new debt?PV = ? c D = 35% ? 100 = $35 million b. If investors pay a tax rate of 40% on interest income, and a tax rate of 20% on income from dividends and capital gains, what is the value of the interest tax shield from new debt? ? * = 1? (1 ? 0. 35)(1 ? 0. 20) = 13. 33% 1 ? 0. 40 PV = ? C D = 13. 33% ? 100 = $13. 33 million MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 15-19. With its curre nt leverage, Impi Corporation will have net income following(a) year of $4. million. If Impis corporate tax rate is 35% and it pays 8% interest on its debt, how much additional debt can Impi issue this year and still receive the benefit of the interest tax shield next year? Net income of $4. 5 million ? 4. 5 = $6. 923 million in taxable income. Therefore, Arundel can increase its interest expense by $6. 923 million, which corresponds to debt of 6. 923 = $86. 5 million 0. 08 MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam.Chapter 16 monetary Distress, Managerial Incentives and Information 16-2. Baruk Industries has no cash and a debt obligation of $36 millionthat is now due. The market value of Baruks assets is $81 million, and the firm has no liabilities. Assume a perfect capital market. a. Suppose Baruk has 10 million shares outstanding. What is Baruks curren t share price? 81 ? 36 = $4. 5 / share 10 b. How many new shares must Baruk issue to raise the capital needed to pay its debt obligation? 36 = 8 million shares 4. 5 c. After repaying the debt, what will Baruks share price be? 81 = $4. 5 / share 18 16-3.When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of loser? No. Some of these losses are due to declines in the value of the assets that would have occurred whether or not the firm defaulted. Only the incremental losses that arise from the bankruptcy process are bankruptcy costs. 16-4. Which type of firm is more belike to experience a loss of customers in the event of monetary distress a. Campbell Soup Company or Intuit, Inc.? Intuit Inc. its customers will care about their ability to receive upgrades to their software. b. Allstate Corporation or Reebok International? Allstate Corporati on its customers rely on the firm being able to pay future claims. MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 16-5. Which type of assets is more likely to be liquidated for close to its up indemnify market value in the event of financial distress? a. An office building or a brand name?Office buildingthere are many alternate users who would be likely to value the property similarly. b. Product inventory or raw materials? Raw materialsthey are easier to reuse. c. Patent right of engineering know-how? Patent rightsthey would be easier to sell to another firm. 16-9. Marpor Industries has no debt and expects to generate free cash flows of $16 million each year. Marpor believes that if it permanently increases its level of debt to $40 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers .As a result, Marpors free cash flows with debt will be only $15 million per year. Suppose Marpors tax rate is 35%, the risk-free rate is 5%, the expected return of the market is 15%, and the beta of Marpors free cash flows is 1. 1. (with or without leverage). a. Estimate Marpors value without leverage r = 5% + 1. 1? (15% ? 5%) = 16% 16 V= = $100 million 0. 16 b. Estimate Marpors value with the new leverage. r = 5% + 1. 1? (15% ? 5%) = 16% 15 V= + 0. 35 ? 40 = $107. 75 million 0. 16 MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam.Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 16-10. Real Estate Purchases are often financed with at to the lowest degree 80% debt. Most corporations, however, have less that 50% debt financing. Provide an explanation for this difference using the trade-off theory. According to tradeoff theory, tax shield adds value while financial distress costs reduce a firms value. The financ ial distress costs for a real estate investment funds are likely to be low, because the property can generally be easily resold for its full market value.In contrast, corporations generally face much broad(prenominal)schooler costs of financial distress. As a result, corporations choose to have lower leverage. 16-11. Dynron Corporations primary business is natural gas transportation using its large gas pipeline network. Dynrons assets currently have a market value of $150 million. The firm is exploring the possibility of raising $50 million by selling part of its pipeline network and place the $50 million in a fiber-optic network to generate revenues by selling fast network bandwidth.While this new investment is expected to increase profits, it will also substantially increase Dynrons risk. If Dynron is levered, would this investment be more or less attractive to equity holders than if Dynron had no debt? If Dynron has no debt or if in all scenarios Dynron can pay the debt in f ull, equity holders will only consider the discombobulates NPV in making the decision. If Dynron is heavily leveraged, equity holders will also gain from the increased risk of the new investment. 16-18. Which of the following industries have low optimal debt levels according to the tradeoff theory? Which have gamy optimal levels of debt? a.Tobacco firms high optimal debt levelhigh free cash flow, low growth opportunities story firms low optimal debt levelhigh distress costs Mature restaurant chains high optimal debt levelstable cash flows, low growth, low distress costs Lumber companies high optimal debt levelstable cash flows, low growth, low distress costs Cell shout manufacturers low optimal debt levelhigh growth opportunities, high distress costs b. c. d. e. MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 6-19. According to the managerial entrenchment t heory, managers choose capital structures so as to preserve their support of the firm. On the one hand, debt is costly for managers because they risk losing control in the event of default. On the other hand, if they do not take advantage of the tax shield provided by debt, they risk losing control through a hostile takeover. Suppose a firm expects to generate free cash flows of $90 million per year, and the give notice rate for these cash flows is 10%. The firm pays a tax rate of 40%. A looter is poised to take over the firm and finance it with $750 Million in permanent debt.The looter will generate the same free cash flows, and the takeover attempt will be successful if the raider can offer a premium of 20% over the current value of the firm. What level of permanent debt will the firm choose, according to the managerial entrenchment hypothesis? 90 = $900 0. 10 Levered Value w/ Raider = 900 + 40%(750) = $1. 2 billion To prevent successful raid,l current managment must have a le vered value of at least $1. 2 billion = $1 billion 1. 20 Thus, the minimum tax sheild is $1 billion 900 million = $100 million, 100 which requires = $250 million in debt 0. 40 Unlevered Value = MBA509RecommendedChapterQuestionsThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. Chapter 17 Payout Policy 17-6. The HNH Corporation will pay a constant dividend of $2 per share, per year, in perpetuity. Assume all investors pay a 20% tax on dividends and that there is no capital gains tax. The cost of capital for investing in HNH stock is 12%. a. What is the price of a share of HNH stock? P=$1. 60/0. 12=$13. 33 b. Assume that precaution make a surprise announcement that HNH will no longer pay dividends but will use the cash to repurchase stocks instead.What is the price of a share of HNH stock now? P=$2/0. 12=$16. 67 17-7. What was the effectuateive dividend tax rate for a U. S. investor in the highes t tax bracket who planned to hold a stock for one year in 1981? How did the effective dividend tax rate change in 1982 when the Reagan tax cuts took effect? (Ignore State taxes. ) 58. 33% in 1981 and 37. 5% in 1982. 17-10. At current tax rates, which investors are most likely to hold a stock that has a high dividend yield? a. Individual Investors b. Pension money c. Mutual Funds d. Corporations 17-11. A stock that you know is held by long-term individual investors paid a large one-time dividend.You notice that the price dropped on the ex-dividend date is about the size of the dividend payment. You find this relationship perplexing given the tax disadvantage of dividends. Explain how the dividends-capture theory world power account for this behavior. Dividend capture theory states that investors with high effective dividend tax rates sell to investors with low effective dividend tax rates just before the dividend payment. The price drop therefore reflects the tax rate of the low e ffective dividend tax rate individuals. MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam.Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. 17-16. Explain under which conditions an increase in the dividend payment can be interpreted as a note of a. Good news By increasing dividends managers signal that they believe that future loot will be high enough to maintain the new dividend payment. b. Bad news Raising dividends signals that the firm does not have any positive NPV investment opportunities, which is bad news. 17-17. Why is an announcement of a share repurchase considered a positive signal?By choosing to do a share repurchase management credibly signals that they believe the stock is undervalued. 17-20. Explain why most companies choose to pay stock dividends (split their stock). Companies use stock splits to keep their stock prices in a range that reduces investor work costs 17-21. When might it be advant ageous to undertake a reverse stock split? To avoid being delisted from an exchange because the price of the stock has fallen below the minimum required to stay listed. 17-22. After the market close on May 11, 2001, Adaptec, Inc. , distributed a dividend of shares of he stock of its software division, Roxio, Inc. Each, Adaptec shareholder received 0. 1646 share of Roxio stock per share of Adaptec stock owned. At the time Adaptec stock was trading at a price of $10. 55 per share (cum-dividend), and Roxies share price was $14. 25 per share. In a perfect market, what would Adaptecs ex-dividend share price be after this transaction? The value of the dividend paid per Adaptec share was (0. 1646 shares of Roxio) ? ($14. 23 per share of Roxio) = $2. 34 per share. Therefore, ignoring tax effects or other news that might come out, we would expect Adaptecs stock price to fall to $10. 5 2. 34 = $8. 21 per share once it goes ex-dividend. (Note In fact, Adaptec stock opened on Monday May 14, 20 01 the next trading day at a price of $8. 45 per share. ) MBA509RecommendedChapterQuestions ThesequestionsarethefocusofwhatIamcoveringonthefinalexam. Understandtheanswerstothesequestionsandshouldnotbesurprisedbyanythingontheexam. Explain the long-term (3 to 5 years) relative stock performance of companies that have i) issued a season equity offering ii) split their stocks Why would a stock split be a signal for good news?What is meant by leaving money on the table, when issuing an IPO? Why might issuing management be content to leave a lot of money on the table? Can you spot the period of a stock market bubble in the table below? (Hint look for an oval ) In retrospect, do you think it is a good long-term investment to purchase stocks where there has been huge amounts of money left on the table? Table 1 Summary Statistics for 6,312 IPOs with fling Price ? $5. 00 Mean First-day Return 7% 15% 65% 12% 19% Average, 2001 Dollars Money left on the Table Gross Proceeds $2. million $10 m illion $82 million $29 million $17 million $42 million $72 million $161 million $397 million $81 million Period 1980-1989 1990-1998 1999-2000 2001-2002 1980-2002 Describe how investment banks allocate IPO shares using the bookbuilding method. Are IPOs, as a group and over time, good long-term investments in terms of average annual returns? Describe how IPOs are like Lotto tickets. (Low expected returns, but with relatively low probability of extremely large gains acquire into Microsoft, Intel, etc) Hint this is the answer.Describe Graham and Kumars suggestive evidence that there is, indeed, a clientele effect for dividends. Which descriptor of investors like high dividend yields? Which age bracket? How do these finding suggest a clientele effect? Chapter14. CapitalStructureinaPerfectMarket Summary 1. Thecollectionofsecuritiesafirmissuestoraisecapitalfrominvestorsiscalledthe firmscapitalstructure. Equityanddebtarethesecuritiesmostcommonly applyby firms. Whenequityisusedwithoutdebt,t hefirmis saytobeunlevered. Otherwise,the amountofdebtdeterminesthefirmsleverage. . The possessorofafirmshouldchoosethecapitalstructurethatmaximizesthetotalvalue ofthesecuritiesissued. 3. Capitalmarketsaresaidtobeperfectiftheysatisfythreeconditions a. Investorsandfirmscantradethesamesetofsecuritiesat belligerentmarket pricesequaltothepresentvalueoftheirfuturecashflows. b. Therearenotaxes,transactioncosts,orissuancecostsassociatedwithsecurity trading. c. Afirmsfinancingdecisionsdonotchangethecashflowsgeneratedbyits investments,nordotheyrevealnewinformationaboutthem. 4.AccordingtoMMPropositionI,withperfectcapitalmarketsthevalueofafirmis independentofitscapitalstructure. a. Withperfectcapitalmarkets,homemadeleverageisaperfectsubstituteforfirm leverage. b. Ifotherwiseidenticalfirmswithdifferentcapitalstructureshavedifferentvalues, theLawofOnePricewouldbeviolatedandanarbitrageopportunitywould exist. 5. Themarketvaluebalancesheetshowsthatthetotalmarketvalueofafirmsassets equalsthetotalmark etvalueofthefirmsliabilities,includingallsecuri tiesissuedto investors.Changingthecapitalstructurethereforealtershowthevalueoftheassetsis dividedcrosswisesecurities,butnotthefirmstotalvalue. 6. Afirmcanchangeitscapitalstructureatanytimebyissuingnewsecuritiesandusing thefundstopayitsexistinginvestors. Anexampleisaleveragedrecapitalizationin whichthefirmborrowsmoney(issuesdebt)andrepurchasesshares(orpaysa dividend). MMPropositionIimpliesthatsuchtransactionswillnotchangetheshare price. 7. AccordingtoMMPropositionII,thecostofcapitalforleveredequityis 8. Debtislessriskythanequity,soithasalowercostofcapital.Leverageincreasestherisk ofequity,however,raisingtheequitycostofcapital. Thebenefitofdebtslowercostof capitalisoffsetbythehigher(prenominal)equitycostofcapital,leavingafirmsweightedaverage costofcapital(WACC)unchangedwithperfectcapitalmarkets 1 9. Themarketriskofafirmsassetscanbeestimatedbyitsunleveredbeta 10. Leverageincreasesthebetaofafirmsequity 11. Afirmsnetdebtisequaltoitsdebtles sitsholdingsofcashandotherrisk? free securities. Wecancomputethecostofcapitalandthebetaofthefirmsbus