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Modigliani and Miller Propositions with Financial Formulas

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1. Compare and contrast the Modigliani and Miller propositions with the Weighted Average Cost of Capital (WACC) approach.
2. According to the textbook author (find reference below), what is a puppeteer? Are puppeteers important to the financial process? Are puppeteers functioning in a good or evil manner? Justify your response.
3. Describe the major capital structure changes that happened to IBM. Which of these structure changes were the most beneficial to the company? What were the major liability categories for IBM, particularly between 2001 and 2003? Substantiate your response.
4. Financial formulas are used to compute the explicit tax-value consequences for different leverage structures. The most widely used formulas are the adjusted present value (APV) and the tax-adjusted weighted average cost of capital (WACC) formulas. Which formula is the best to use under various situations? Provide some examples to justify your response.

Textbook: Welch, I. (2009). Corporate finance: An introduction. Upper Saddle River, NJ: Prentice Hall.

Please cite other references. Thanks for your help.

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1. The Modigliani and Miller theory is essentially a theoretical perspective that proposes that there is no correspondence or absolute connection between the manner in which an organization finances its operations, or receives its initial financing, and the subsequent financial value of that given firm. In essence, the value of a firm is based upon its efficiency and effectiveness within a given market, as well as its ability to function under the various internal and external conditions that are commensurate with economic conditions at any given time. Due to this factor, if an organization is financed through the use of capital firm investors, or if this organization is financed through the selling of shares of stock, there will be no significant and appreciable differential in the subsequent value of that particular firm (Welch, 2009). This theory contrasts with the weighted average cost of capital approach, due to the fact that the weighted average cost of capital approach presupposes that an organization must earn a certain amount of profit on its holdings and or assets in order to keep investors satisfied with their investment decision. In addition, there is an absolute minimum that an organization can profit on its holdings or assets, and maintain the satisfaction of investors as well as creditors in many respects. In essence, if the organization does not perform up to par in respect to profitability that is satisfactory to its investors etc., then this theory advocates that these investors would discontinue their investments and or the maintenance of their holdings with ...

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Corporate Finance: Capital Structure, Modigliani-Miller Proposition, NPV, Working Capital, Accelerated Depreciation, corporate bankruptcies, LBO, currencies

1) You're trying to figure out why the chairman of the Board of Directors fired you as CEO of a small corporation. You never missed an interest payment and the firm had a cash ratio of 2, the highest of any firm in their peer group. Because of this financial safety net, the firm's debt was considered very safe by industry standards. Why were you fired? Be specific.

2) Acme Widgets Inc. has steady earnings (EBIT), and is an average firm in most ways in the widget industry. The one exception is it has the highest debt-equity ratio of any firm in its industry. It has regularly sold most of its bonds over the last 40 years to Ajax Holdings, a large institutional investor (like a pension fund or an insurance company). Given the lessons of Modigliani-Miller Proposition #1, explain Acme's unique capital structure?

3) You work for Campbell's Soup. Your boss has asked you to calculate the NPV of a new line of chewing gum which will have some of the firm's popular flavors (e.g. Chicken Noodle Gum). You estimate the annual revenues for this project will be $500,000, cost of goods sold will be $200,000, new equipment will cost $800,000 and will be depreciated completely over the project's life (four years, straight line). The project will also need $100,000 in working capital (immediately), which will be recouped in the final year. The building adjacent to your existing factory will be rented for this project at an annual cost of $50,000. You accumulated $10,000 in overtime pay figuring all of this stuff out. The firm's current cost of capital is 10% and their D/E = 2. A potentially relevant publicly traded chewing gum company's financial information is:

ßstock = 1.5 ßdebt = 0.5 rf = 4%

E(rmkt) = 12% Tax Rate = 50% D/E = 2.0

What is this project's NPV?

4) A pizza shop owner is asking for a loan from the bank where you work as a loan officer. She tells you that she's been in business for five years and this is the best year she's ever had. She says that half of her business comes from deliveries. She indicates that she's been frugal to a fault and muses that she decided not to change the store's original logo because she would have to repaint the old delivery vans. She shows you several accounting ratios from this year's financial statements to support her loan application and she focuses on her TIE of 2 and her Debt/Total Assets of 0.5. Based on what she has told you, what two pieces of additional information would you like before you proceed? Note: This information should pertain to the two ratios she focused on (individually) and your reasons for wanting this information should be related to her description of her business.

5) ABC Inc. is a nonprofit and thus pays no corporate taxes. XYZ Inc. is a for-profit firm whose current corporate tax rate is 40%. They are in the same business. In setting up operations, ABC chose to use fewer fixed assets (plant and equipment). As a result of that, they have higher expenditures on working capital (in a sense, substituting inventories for machines). Why did XYZ choose more fixed assets and lower working capital expenditures?

Both of these companies are considering getting a new copier. Which of them is more likely to lease it? Why?

6) The stock of BFD Inc. is selling for $5/share. Its assets have a book value of $12 and it has liabilities of $5 (both per share). What is BFD's market to book ratio? Show how you could break up this company and make a profit? What important assumption underlies this potential profit?

7) Your boss at Stanley Tools is disappointed. The firm has decided to branch out into some new industries and he wanted the firm to enter the potato chip industry. Unfortunately, the careful analysis that you provided him ended up showing a negative NPV. He asks you to consider the following changes in order to make the project work:

a. Accelerated Depreciation (you used straight line)
b. Leasing the manufacturing equipment
c. Eliminating Accounts Receivable and Inventory to save working capital costs
d. Switching to the Stanley's current (lower) WACC

Of the four, which one is least likely to increase this project's NPV? Explain.

Of the four, which one should you reject as an inappropriate use of good finance principles?

Of the four, which one would be best using good business and finance principles? Explain.

8) In Slobovia, an obscure European country, dividends and interest are given the same tax treatment: they are both deductible at the corporate level and both taxed as income at the investor's level. All else the same, where would you expect more corporate bankruptcies, in Slobovia or in the US? Explain.

9) Your firm has had steady earnings for many years but it has resisted paying dividends. It typically uses its earnings to finance the replacement of its worn out assets, thus saving the cost of borrowing for that purpose. Your firm's. stock price has not risen much in recent years. A Drucker-educated consultant tells the CEO to start paying a modest dividend out of earning. "The borrowing costs you will incur by occasionally having to raise money with debt will be outweighed by a subtle benefit." What subtle benefit is the consultant referring to?

10) United Cut and Scab is a large, profitable consumer products company. After being taken over in an LBO, they cease their common practice of merging with small, R&D-oriented biotech firms. Why?

11) Over the past year, the dollar has depreciated by about 10% against the Euro. A year ago you took out a home equity loan in the US at an interest rate of 8% and you invested the money in a German mutual fund that paid a 5% Euro return. What net return did you earn on all of these transactions over the year?

See attached file for full problem description.

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