Question

3. The firm is an all-equity firm with assets worth $350 million and 100 million shares outstanding. It plans to borrow $100 million and use these funds to repurchase shares. The firm’s marginal corporate tax is 21%, and it plans to keep its outstanding debt equal to $100 million permanently. If the firm manages to repurchase shares at $4 per share, what is the per share value of equity for the leveraged firm?

A) $2.71 per share

B) $3.5 per share

C) $3.61 per share

D) $3.71 per share

E) $4 per share

2. Which of the following statement is true regarding the Modigliani and Miller (M&M) propositions (1958) in a perfect financial market? A) Capital structure is irrelevant because of the assumption that investors and companies have differing tax rates.

B) It is assumed that the firm’s future cash flows remain fixed under any circumstances.

C) The basic lesson of M&M propositions is that company’s capital budgeting decisions are dependent upon the company's capital structure decision.

D) The debt-to-equity ratio is an important measure of the firm’s operational risk. E) The firm’s cost of capital (WACC) is not affected by leverage; however, the firm’s cost of equity RE may be affected by leverage.

Answer 1

Answer:

Value of equity without leverage = $350m

If firm borrows $100m permanent debt.

PV of tax shield from raising debt = 21% * $100m

PV of tax shield from raising debt = $21m

Total value of levered firm will be $350m + $21m = $371m

Firm has raised $100m debt. So, value of equity will be $371m - $100m = $271m

Company will use $100m to purchase the shares at $4 per share. So total shares will be purchased is $100m/$4= 25m shares

O/s shares after repurchase = 100m-25m = 75m

Per share value of levered firm will be = $271m/75m

= $3.61

Option C

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