Ch_15_Mini_Case

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Ch 15 Mini Case 3/3/2003 Chapter 15. Mini Case Situation Modigliani and Miller without Taxes Proposition I. 1. The weighted average cost of capital is independent of the firm's capital structure. 2. The WACC of a firm with debt is equal to the unlevered cost of equity. Proposition II. Input Data Firm U Firm L No Debt Some Debt EBIT \$500,000 \$500,000 Debt \$0 \$1,000,000 na 8.0% 14% na Value of Firm \$3,571,429 \$3,571,429 Value of Equity \$3,571,429 \$2,571,429 + x (D/S) 14% + 6.00% x 0.39 16.33% WACC = + = + WACC = 2.24% + 11.8% David Lyons, the CEO of Lyons Solar Technologies, is concerned about his firm's level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30 percent debt, and Mr. Lyons wonders why the difference occurs, and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant. a. Business Week recently ran an article on companies' debt policies, and the names Modigliani and Miller (MM) were mentioned several times as leading researchers on the theory of capital structure. Briefly, who are MM, and what assumptions are embedded in the MM and Miller models? Answer: See Chapter 15 Mini Case Show Franco Modigliani and Merton Miller developed a model to examine the impact of debt on firm value. In this first version it is assumed that taxes are zero. 1. Assume that Firms U and L are in the same risk class, and that both have EBIT = \$500,000. Firm U uses no debt financing, and its cost of equity is r s U = 14%. Firm L has \$1 million of debt outstanding at a cost of r d = 8%. There are no taxes. Assume that the MM assumptions hold, and then: a. Find V, S, r s , and WACC for Firms U and L. The cost of equity, r sL = r sU + Risk premium = r sU + (r sU -r d )(D/S) r d r s Value of Firm = (EBIT/r s ) r sL = r sU (r sU -r d ) r sL = r sL = w d *r d w ce *r s (D/V)*r d (S/V)*r s A B C D E F G H I 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

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WACC = 14.00% MM without Taxes D V S D/V WACC 0.0 \$3.50 \$3.50 0.00% 8.00% 14.00% 14.00% 0.5 \$3.50 \$3.00 14.29% 8.00% 15.00% 14.00% 1.0 \$3.50 \$2.50 28.57% 8.00% 16.40% 14.00% 1.5 \$3.50 \$2.00 42.86% 8.00% 18.50% 14.00% 2.0 \$3.50 \$1.50 57.14% 8.00% 22.00% 14.00% (2.) Graph (a) the relationships between capital costs and leverage as measured by D/V, and (b) the relationship between value and D. Modigliani and Miller with CorporateTaxes The MM results are different once corporate taxes are added in. Proposition I ( with corporate taxes)
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