Kiwi Ltd is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Aussie Ltd is identical in all respects to Kiwi Ltd, except that it has $12 million in debt at an interest rate of 5% p.a. Both firms generate a cash flow of $10 million annually. Suppose that there are no taxes, and after paying any interest on debt, both companies use all remaining cash free cash flows to pay dividends each year.

 

Assume Miller and Modigliani (MM) perfect capital markets with no taxes and that both firms and individuals can borrow and lend at the same 5% rate as Aussie Ltd.

 

(a) According to MM Proposition 1, what is the stock price for Aussie Ltd?

(b) According to MM Proposition 1, which firm would you invest in if the equity of Aussie Ltd was valued at $10 million? Briefly justify your choice.

 

(c) Given your answer to part (b), show how you could make a riskless arbitrage profit if you wanted a 10% ownership stake of the firm. Give a full explanation of the transactions needed and the amount of profit to be made.

(d) What is the optimal capital structure in MM perfect capital markets with no taxes?