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QUESTION THREE (a) Modigliani and Miller's (1963) demonstration of the existence of tax savings of debt implies the optimal debt ratio to be 100% debt (near exclusion of equity financing). However, this is not consistent with observed firm behavior: in reality, firm's debt does not go that high. Describe how Modigliani and Miller (1963) attempted to explain the inconsistency of their result with observed firm behavior. (b) The standard case of the Modigliani-Miller theorem on capital structure assumes that the firm has. Only two classes of securities, namely perpetual debt and equity. Suppose that the firm has issued preferred stock as a third class securities, and that X%% of preferred dividends may be written off as. An expense (0 S X $ 1), derive the appropriate expression for: (1). the value of the levered firm; (li). the weighted average cost of capital