Finance
COMM370 – Alejandra Medina
Practice for Lecture 12-13: Modigliani-Miller Propositions
Question 1. Prove Modigliani-Miller proposition 1 with corporate taxes. As part of your answer, clearly state the underlying assumptions, explain the intuition underlying the proof, and conceptually interpret the meaning of the proposition.
Note: you should be able to formally prove MM 1 & MM2 as we did in class.
Question 2. Levered Inc. and Unlevered Inc. are identical in every respect except for capital structure. Both companies expect to earn $150 million in perpetuity, and both distribute all of their earnings as dividends. Levered’s perpetual debt has a market value of $300 million and the required return on its debt is 7%. Levered’s stock sells for $100 per share, and there are 5 million shares outstanding. Unlevered has 8 million shares outstanding worth $90 each.
Unlevered has no debt. These firms operate in the Modigliani-Miller world with no taxes. How can you take advantage of this scenario?
Question 3. Northrop has 80 million shares worth $10 per share and no debt. Its cost of capital is 5%. It has a perpetual random CF with mean $40 million and it pays no taxes.
Northrop plans a leveraged recapitalization, in which it will issue $300 million in perpetual debt at an interest rate of 2% per year and use the proceeds to repurchase shares. The firm operates in the Modigliani-Miller world with no taxes.
a) What are Northrop’s firm value, cost of equity, and WACC before the recapitalization?
b) What are Northrop’s firm value, equity value, debt value, cost of equity, and WACC after the recapitalization? Compare you results to those in a) and interpret the differences.
c) What happens with Northrop’s equity values and share price at the time of the announcement but before the recapitalization is executed?
d) How many shares can Northrop repurchase and how many shares outstanding are left after the transaction?
Question 4. Vortex has 70 million
Practice for Lecture 12-13: Modigliani-Miller Propositions
Question 1. Prove Modigliani-Miller proposition 1 with corporate taxes. As part of your answer, clearly state the underlying assumptions, explain the intuition underlying the proof, and conceptually interpret the meaning of the proposition.
Note: you should be able to formally prove MM 1 & MM2 as we did in class.
Question 2. Levered Inc. and Unlevered Inc. are identical in every respect except for capital structure. Both companies expect to earn $150 million in perpetuity, and both distribute all of their earnings as dividends. Levered’s perpetual debt has a market value of $300 million and the required return on its debt is 7%. Levered’s stock sells for $100 per share, and there are 5 million shares outstanding. Unlevered has 8 million shares outstanding worth $90 each.
Unlevered has no debt. These firms operate in the Modigliani-Miller world with no taxes. How can you take advantage of this scenario?
Question 3. Northrop has 80 million shares worth $10 per share and no debt. Its cost of capital is 5%. It has a perpetual random CF with mean $40 million and it pays no taxes.
Northrop plans a leveraged recapitalization, in which it will issue $300 million in perpetual debt at an interest rate of 2% per year and use the proceeds to repurchase shares. The firm operates in the Modigliani-Miller world with no taxes.
a) What are Northrop’s firm value, cost of equity, and WACC before the recapitalization?
b) What are Northrop’s firm value, equity value, debt value, cost of equity, and WACC after the recapitalization? Compare you results to those in a) and interpret the differences.
c) What happens with Northrop’s equity values and share price at the time of the announcement but before the recapitalization is executed?
d) How many shares can Northrop repurchase and how many shares outstanding are left after the transaction?
Question 4. Vortex has 70 million