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No-arbitrage pricing.
Value
Comments
Straight swap of equity for debt
Market prices unchanged
Real asset unchanged
12.00
Debt
10.00
Break-even
Point
EPS
8.00
6.00
4.00
No Debt
2.00
0.00
EBIT
1,000
(2.00)
2,000
3,000
Homemade leverage
Instead of the firm swapping equity for
debt.
The investor does it himself, by
borrowing.
It works out just as well.
Homemade annihilation of
leverage
Proposition II of M-M
B is value of debt
SL is value of levered equity
Quick derivation of MM II
Uses MM I. Value unchanged.
Uses cash flow constraint.
MM I
Cash
SU S L B
r0 SU rS S L rB B
r0 ( S L B) rS S L rB B
rS S L r0 ( S L B ) rB B
rS S L r0 ( S L B ) rB B
rS S L r0 S L (r0 rB ) B
B
rS r0 (r0 rB )
SL
MM Proposition II no tax
Cost of
capital: r
(%)
r0
B
rS r0 (r0 rB )
SL
rS
rWACC
rB
Debt-toequity
ratio (B/S)
Exam review
Answer
Pay-off pitch
WACC =
(S/(S+B))rS + (B/(S+B))(1-TC)rB