1. Sophie Pharmaceuticals Ltd has 9.6 million ordinary shares on issue. The current market price is $12.50 per share. However, the company manager knows that the results of some recent drug tests have been remarkably encouraging, so that the 'true' value of the shares is $13. Unfortunately, because of confidential patent issues, Sophie Pharmaceuticals cannot yet announce these test results. In addition, Sophie Pharmaceuticals has a property investment opportunity that requires an outlay of $15 million and has a net present value of $2.5 million. At present, Sophie Pharmaceuticals has little spare cash or marketable assets, so if this investment is to be made it will need to be financed from external sources. The existence of this opportunity is not known to outsiders and is not reflected in the current share price. Should Sophie Pharmaceuticals make the new investment? If so, should the investment be made before or after the share market learns the true value of the company's existing assets? Should the investment be financed by issuing new shares or by issuing new debt?
2. 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 distribution equals zero is: VL = VU + {1- (1-tC-/1-tB)} x B - C-B

Where VL = The value of a levered firm

VU = The value of an unlevered firm

B = The value of the firm's debt

tC = The tax rate on corporate income

tB = the personal tax rate on interest income

C-B- = The present value of the costs of financial distress

a- In their no-tax model, what do Modigliani and Miller assume about tC, tB and C-B-???? What do these assumptions imply about a firm's optimal debt-equity ratio?

b- In their model with corporate taxes, what do Modigliani and Miller assume about tC , tB and C-B-?

What do these assumptions imply about a firm's optimal debt-equity ratio?

c- Consider an all equity firm that is certain to be able to use interest deduction to reduce its corporate tax bill- If the corporate tax is 34 percent, the personal tax rate on interest income is 20 percent, and there are no costs of financial distress, by how much will the value of the firm change if it issues $1 million in debt and uses the proceeds to repurchase equity?

d- Consider another all equity firm that does not pay taxes due to large tax loss carry forwards from previous years- The personal 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 $1 of perpetual debt rather than of $1 equity?