8. Modigliani Corporation and Miller Ltd are two remarkably similar companies. Each has the same asset base and both face identical future investment opportunities. Indeed, the only discernible difference between the two is that Miller Ltd is financed completely by equity capital, whereas Modigliani Corporation has some $500,000 of debt in its capital structure (at ko = 8%). The companies are also fortunate in that they operate in perfect capital markets, with no costs or taxes, in which all market participants have equal information access. The earnings of the companies, and other relevant market information, are as follows. Miller $100,000 Net operating income Interest on debt Earnings available to shareholders Equity cost of capital Market value of equity Market value of debt Total value of firm Implied cost of capital $100,000 0.10 $1,000,000 Modigliani $100,000 40,000 $60,000 0.10 $600,000 500,000 $1,100,000 0.091 $1,000,000 0.10 (a) Describe how you would act to realise a risk-free profit if you held 5% of the shares in Modigliani Corporation, and the situation outlined above was continuing. State the amount of profit you could make. (b) Assuming that arbitrage activities occurred such that the market values of these companies became equal, what is Modigliani's correct cost of capital (ko)? Why does ko remain the same under the M&M scenario, when debt is clearly cheaper than equity and should therefore lower the overall cost of capital when added to a firm's capital structure? (c)