Question

Two firms, A Ltd and B Ltd operate in the same industry. The two firms are...

  1. Two firms, A Ltd and B Ltd operate in the same industry. The two firms are similar in all aspects except for their capital structures. The following additional information is available.
  1. A Ltd is financed using $100million worth of ordinary shares.
  2. B Ltd is financed using $50 million in ordinary shares and $50 million in 7% debentures.
  3. The annual earnings before interest and Tax are $10 million for both firms. These earnings are expected to remain constant indefinitely.
  4. The cost of Equity in A Ltd is 10%
  5. The corporate Tax rate is 30%.

Required:

Using the Modigliani and Miller (MM) model, determine the market value of A Ltd and B Ltd

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Answer #1

As per Modigliani and miller approach, market value of a firm is present value of it expected earnings and firm's capital structure does not merely affects the value of firm but tax benefit available to levered firm will increase the value of firm.A firm having debt is more likely to have higher firm value than all equity firm.

Value of A limited(Unlevered company) : Earning before interest and taxes(1-tax rate) / cost of equity

= $10(1 - .30) / 0.10

= $70 million

Value of B ltd.(Levered company):

= value of unlevered firm + tax benefit

= $70m + ($50*7%*30%)/7%

=$85

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