Charlie Smith, CEO of Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30 percent debt, and Mr. Smith wonders why they use so much more debt, and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:

A. Business Week recently ran an article on companies debt policies, and the names Modigliani and Miller (MM) were mentioned several times as leading researchers on the theory of capital structure. Briefly, who are MM, and what assumptions are embedded in the MM and Miller models?

B. Assume that firms U and L are in the same risk class, and that both have EBIT = $500,000. Firm U uses no debt financing, and its cost of equity is r_sU = 14%. Firm L has $1 million of debt outstanding at a cost of r_d = 8%. There are no taxes. Assume that the MM assumptions hold, and then:

1. Find v, s, r_s, and WACC for firms U and L.
2. Graph (a) the relationships between capital costs and leverage as measured by D/V, and (b) the relationship between value and D.

C. Using the data given in part B, but now assuming that firms L and U are both subject to a 40 percent corporate tax rate, repeat the analysis called for in B(1) and B(2) under the MM with-tax model.