Question

Assume you are in a modigliani miller world ( MM propositions I and II hold). AB corporation is unlevered and has net operating income of sh.90,000. Its cost of equity is 15% . AB is currently deciding whether including debt in their capital struture would INCREASE the company;s value. Under considerartion is issuing sh. 240,000 in new debt with an 8% interest rate. AB would repurchase sh. 240,000 of stock with the proceeds of the debt issue. There are currently 30,000 shares outstanding. The company is exempt from income tax.

Required

Determine the impact of the decision on

i) Firm value

ii) cost of equity

iii) weighted average cost of capital

iv) the share price

Answer 1

i), ii) & iii)

Since cost of equity > cost of debt and (value of equity+ value of debt) remains constant, therefore after debt issuance, WACC (wieghted average cost of capital) decreases. Since WACC decrease, firm value increases

iv) Share price = Firm value/ No . of shares. Since firm value increases and no of share decreases, share price increases