Question Two (10 Marks)

In relation to personal Taxes, Bankruptcy Costs, and Firm Value, when personal taxes on interest income and bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distributions equals zero is: V = V, + {1 - [(1 - 1)/(1 - 1)]} X B - C(B)

Where: V = The value of a levered firm. V = The value of an unlevered firm. B = The value of the firm's debt. 1.= The tax rate on corporate income. 1, = The personal tax rate on interest income. CB) = The present value of the costs of financial distress.

Requirements:

1. In the 1958 M&M model, what is the assumption for Modigliani and Miller in relation to t, tb, and C

2. What is their implication about a firm's optimal debt-equity ratio?

3. In the 1963 M&M model, what is the assumption for Modigliani and Miller about t, tB, and C(B)? What is their implication about a firm's optimal debt-equity ratio? If Consideration is made for an all-equity firm that is certain to be able to use tax savings to reduce its corporate tax liability. If the corporate tax rate is 35 percent, with Holding Tax rate on interest income is 15% percent, and there are no financial distress costs, what would be the change in value of the firm if it issues K1 million in debt and uses the proceeds to repurchase equity?

4. Consideration is made for another all-equity firm which doesn't pay taxes due to tax losses from the previous years. The withholding tax rate on interest income is 20 percent, and there are no costs of financial distress. What would be the change in the value of this firm from adding K1 of perpetual debt rather than K1 of equity?