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Modigliani-miller approach

Assume a world without taxes. Two firms, Mix Corp. and Dial Co. are identical in every way except for their capital structures. Mix, an all-equity firm, has 200000 shares of common stock outstanding; each share sells for $30. In addition to equity financing, Dial uses leverage; the market value of Dial's debt is $3,000,000, and the interest rate on this debt is 8 percent. Both firms are expected to have EBIT (Earnings before interest and taxes) of $700,000 each year for the foreseeable future. Suppose that investors can borrow and lend at the same rate as the firms. Show that the Modigliani-Miller Proposition I holds. (Hint: Show, by the way of example, that homemade leverage is a perfect substitute for corporate borrowing).

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Answer attached in excel sheet.

The rate of cost of equity of 9% and 13% are purely the assumptions.Now, the question is why 9% for the first firm and 13% for the second firm.The reason being, ...

Solution Summary

The answer contains Modigliani-Miller approach,its assumption and also explains by illustration how the home made leverage is the perfect substitute for corporate borrowing.