Problem:

(a) Companies A and B differ only in their capital structure. A is financed  by  30 percent debt and 70 percent equity; B is financed 10 percent debt and 90 percent equity. The debt of both companies is risk-free.

(i) Rosencrantz owns 1 percent of the common stock of A. What other investment package would produce identical cash flows for Rosencrantz?

(ii) Guildenstern owns 2 percent of the common stock of B. What other investment package would produce identical cash flows for Guildenstern?

(iii) Show that neither Rosencrantz nor Guildenstern would invest in the common stock of B if the  total value of company A were less than that of B.

(b) "Modigliani and Miller totally ignore the fact that as you borrow more, you have to pay higher rates of interest." Explain carefully whether this is a valid objection.