Question

An all-equity firm has a cost of equity of 11% and expects its EBIT will be $2,200,000 every year forever. The firm is considering borrowing $4,000,000 and using the proceeds to repurchase shares. Assume all the Modigliani and Miller (M&M) assumptions are satisfied and all available earnings are immediately distributed to common shareholders. According to M&M Proposition I without taxes, what would the value of the firm be after the capital restructuring?

Answer 1

Answer:

Value of the firm before Capital Restructuring = EBIT/Cost of Equity

Value of the firm before Capital Restructuring = $ 2,200,000 / 11%

Value of the firm before Capital Restructuring = $ 20,000,000

As per Modigliani and Miller approach, The WACC remains constant irrespective of its Capital Structure. Thus, the market value of the company is also remains constant. Therefore, a company cannot reduce its WACC and alter its Market Value by altering its Capital Structure.

Hence though Capital structure is altered, i.e., Borrowing Funds and buying back equity, The WACC of the Company remains unaltered and Total value of the firm remains same as the Value of the firm before Capital Restructuring = $ 20,000,000.

However, The Modigliani-Miller theorem was developed with an assumption that there will be no taxes.

There will be no Costs involved in raising Funds.