You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $ 21 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $4.5 million. Investors are willing to provide you with $4.5 million in initial capital in exchange for 25 % 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 $3.8 million you need? c. What is the value of your share of the firm's equity in cases (a) and (b)?
a) Since, the investors are willing to provide $4.5 million in initial capital in exchange of 25% of the unlevered equity in the firm, the investors value the firm for $18 MN:
Investors's investment = $4.5 million
Share in equity = 25%
Market value of the firm = $4.5 million/0.25 = $ 18 Mn
b) Firm borrowed $ 0.7 million
Additional amount to be raised = $3.8 million
Firm's equity = Market value - borrowed amount = $18Mn- $0.7 million = $ 17.3 million
Percentage of firm's equity to be sold= Amount to be raised/ Firm's equity = $3.8 million/$17.3 million = 21.96%
c) Value of own share in firm's equity:
In case A: 75% * 18MN = $13.5 MN
In case B: 17.3* (1-0.2196) = $13.5 MN
Hence, in a perfect market choice of capital structure does not affect the value.
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