Question

John Lee, the CFO of Mpota Limited has just completed a training program on Modigliani and Miller’s (M&M) propositions on capital structure. John Lee is excited about M&M propositions and has decided to issue bonds and use the proceeds to buy back shares.

(i) Based on your understanding of M&M propositions, why do you think Mr Lee has decided to issue bonds and use the proceeds to buy back shares?

(ii) Briefly describe 5 issues Mr Lee should consider before he issues bonds and use the proceeds to buy back shares.

Answer 1

1.
As interest payments on debt are tax deductible, issuing bonds to buy back shares increases the value of the firm

2.
Identify whether stock is undervalued or not
Identify the impact on WACC, does it move to optimal capital structure or away from it
Identify whether the firm will generate sufficient cash flows to service debt
Identify the increase in chances of bankruptcy
Identify whether the additional interest payments will be tax exempt or not as there is a limit to the exemption