You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $ 27 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $5.6 million. Investors are willing to provide you with $5.6 million in initial capital in exchange for 30 % of the unlevered equity in the firm.
a. What is the total market value of the firm without leverage?
b. Suppose you borrow $0.7 million. According to MM, what fraction of the firm's equity will you need to sell to raise the additional $4.9 million you need?
c. What is the value of your share of the firm's equity in cases (a) and (b)?
Given
Project Value can be
i) 27 Million
ii) 0 Million
Funding Needed 5.6 million
A.
An investor is willing to pay 5.6 million for 30%
equity
Which Means market value of Firm = (5.6/30) * 100
= 18.6667 Million
Market Value Of Firm (without Leverage) =
18.6667
B.
Borrow 0.7 Million
According to MM Theory: proposition 1
The Value of the firm (with Leverage/Debt) = Value of the firm
(without Debt/Leverage)
We have the Value of the firm (without debt) = 18.6667 = Value
of the firm (with Debt)
The Value of the firm
(With Debt) = Value of Debt + Value of Equity
18.6667 = 0.7 (GIVEN) + Value of Equity
Value of Equity = 18.6667 - 0.7 = 17.9667
According to MM Theory: proposition 2
Financial leverage is in direct proportion to the cost of equity.
With an increase in debt, the equity shareholders perceive a
higher risk. Hence, expect a higher return, thereby
increasing the cost of equity.
Funding Needed = 4.9 million
Percentage of Equity = (4.9/17.9667) * 100
= 27.27273%
C.
Value of My Share in case
a).
Market Value of Equity = 18.6667
Investor's Share = 30%
My share = 70%
Value of My Share of the firm's equity =.70*18.6667
= 13.0667
b).
Market Value of Equity = 17.9667
Investor's Share = 27.273%
My share = 72.727%
Value of My Share of the firm's equity
=.72727*17.9667
= 13.0667
In Both Cases, The cases Value of My Share of the firm's
equity is the same.
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