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Topic 8 Tutorial Solutions v2-1-1

The document discusses the Modigliani-Miller proposition I, which asserts that a firm's capital structure does not influence its value, as investors can replicate any changes at no cost. It also covers Miller's arguments regarding the relationship between debt, taxes, and corporate financing decisions, illustrating how changes in financial leverage affect the overall cost of capital. Additionally, it includes tutorial questions with calculations related to debt, equity, and weighted average cost of capital (WACC) for specific companies.

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cblinh12062005
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7 views3 pages

Topic 8 Tutorial Solutions v2-1-1

The document discusses the Modigliani-Miller proposition I, which asserts that a firm's capital structure does not influence its value, as investors can replicate any changes at no cost. It also covers Miller's arguments regarding the relationship between debt, taxes, and corporate financing decisions, illustrating how changes in financial leverage affect the overall cost of capital. Additionally, it includes tutorial questions with calculations related to debt, equity, and weighted average cost of capital (WACC) for specific companies.

Uploaded by

cblinh12062005
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Topic 8 – Tutorial Questions + Answers

Discussion Questions

State the generalized version of Modigliani-Miller proposition I.

Modigliani-Miller proposition I states that changes in capital structure does not affect the value of a firm. MM's
proposition I is an extremely general result. Any change in the capital structure of the firm can be duplicated or
"undone" by the investors at no cost. The investors need not pay extra for borrowing indirectly (by holding shares
in a levered firm) when they can borrow just as easily and cheaply on their own account. It applies equally to
trade-offs of any choice of financial instruments. For example, the choice between long-term debt and short-term
debt would also not affect the value of the firm. Generally, the choice between issuing preferred stock, common
stock, or some combination of the two should not have any effect on the overall value of the firm. It also applies
to the mix of debt securities issued by the firm. The choices of long-term versus short-term, secured versus
unsecured, senior versus subordinated, and convertible and nonconvertible debt all should not have any effect on
the overall value of the firm.

Discuss the basic idea behind Miller's arguments about debt and taxes.

In equilibrium, taxes determine the aggregate amount of corporate debt but not the amount issued by any
particular firm. For a given set of tax rates, both corporate and personal, the market will adjust until there is no
advantage to any firm issuing more debt.

Question 1

“Increasing financial leverage increases both the cost of debt (rdebt) and the cost of equity (requity). So the overall
cost of capital cannot stay constant.” This problem is designed to show that the speaker is confused. Buggins Inc.
is financed equally by debt and equity, each with a market value of $1 million. The cost of debt is 5%, and the cost
of equity is 10%. The company now makes a further $250,000 issue of debt and uses the proceeds to repurchase
equity. This causes the cost of debt to rise to 5.5% and the cost of equity to rise to 10.83%. Assume the firm pays
no taxes.

a. How much debt does the company now have?


b. How much equity does it now have?
c. What is the overall cost of capital?

a. Debt after capital restructuring = $1,000,000 + $250,000 = $1,250,000

b. Equity after capital restructuring = $1,000,000 – $250,000 = $750,000

$1,250,000 $750,000
c. 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 5.5% × + 10.83% × = 7.5%
$2,000,000 $2,000,000
Question 2

Omega Corporation has 10 million shares outstanding, now trading at $55 per share. The firm has
estimated the expected rate of return to shareholders at about 12%. It has also issued $200 million of
long-term bonds at an interest rate of 7%. It pays tax at a marginal rate of 35%.

a. What is Omega’s after-tax WACC?


b. How much higher would WACC be if Omega used no debt at all? (Hint: For this problem you can
assume that the firm’s overall beta [βA] is not affected by its capital structure or by the taxes saved
because debt interest is tax-deductible.)

Assuming that $200 million of long-term bonds have been issued:

a. D = $200 million
E = $55 × 10m
E = $550 million
V=D+E
V= $200m + 550m
V = $750 million

After-tax WACC = rD(1 – TC)(D / V) + rE(E / V)


After-tax WACC = .07(1 – .35)($200m / $750m) + .12($550m / $750m)
After-tax WACC = .1001, or 10.01%

b. The after-tax WACC would increase to the extent of the loss of the tax deductibility of the interest
on debt. Therefore, the after-tax WACC would equal the opportunity cost of capital, computed
from the WACC formula without the tax-deductibility of interest:

After-tax WACC = rD(D / V) + rE(E / V)


After-tax WACC = .07($200m / $750m) + .12($550m / $750m)
After-tax WACC = .1067, or 10.67%
Question 3

Here are book and market value balance sheets of the United Frypan Company (UF):

Assume that MM’s theory holds with taxes. There is no growth, and the $40 of debt is expected to be permanent.
Assume a 40% corporate tax rate.

a. How much of the firm’s value in dollar terms is accounted for by the debt-generated tax shield?
b. How much better off will UF’s shareholders be if the firm borrows $20 more and uses it to repurchase
stock?

a. PV tax shield = TcD


PV tax shield = .40 × $40
PV tax shield = $16

b. Increase in equity = Tc × increase in debt


Increase in equity = .40 × $20
Increase in equity = $8

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