Question

There are two firms, Hello and olleH. Each has expected Net Operating Income (NOI) of $18 million each year forever, and the cash flow to Hello will always be exactly the same as that to olleH, whether it ends up above or below the expected amount. Hello is all equity (stock). olleH has some equity, along with $100 million in debt (market value and face value). olleH’s debt pays 5% interest at the end of each year, and olleH has expected return on its equity of 6.5%. There are no taxes, and the rest of the Modigliani-Miller assumptions hold.

a.	What is the expected cash flow to olleH equity holders each year?
b.	What is the value of olleH equity?
c.	What is the value of Hello equity?
d.	What is the expected return on Hello stock?

Answer 1

a. olleH equity holders get NOI minus debt payments=18M – 100M(0.05) = 13M annually

b. Value of olleH equity = the perpetuity of 13M, with an 6.5% expected return

= 13M/6.5%

= 200M

c. Hello is exactly the same operationally as olleH, so it must have the same firm value.

olleH’s value =200M + 100M = 300M, so this must Hello’s value. Hello has no debt, so its equity value = firm value = 300M

d. With value 300M and perpetual cash flow 20M, the expected return must satisfy the equation: 300 = 18M/r

Thus r = 18M/300

= 6%

(Please note that “M” stands for million)