Question 2

Ahmad Al-Abab is the founder and CEO of UM Corp, a regional company

that operates several educational and training services. The company
plans to open more agencies and the success of the new agencies will
depend on the state of the economy over the next few years. The
company currently has a bond issue outstanding with a face value of RM68
million that is due in one year. Covenants associated with this bond issue
prohibit the issuance of any additional debt. Hence, the companys
expansion must be entirely financed with equity at a cost of RM16.8
million. The table below shows the value of the company in each state of
the economy next year, both with and without expansion:

(a) Calculate the expected value of the company and the expected value
of the companys debt in one year, with and without expansion?
The expected value of the company without expansion is:
VD= .30(RM60 million) + .50(RM70 million) + .20(RM102 million)
VD= RM18 million + RM35 million + RM20.4 million
VD= RM73.4 million
And the value of the company with expansion is:
VD= .30(RM66 million) + .50(RM92 million) + .20(RM128 million)
VD= RM19.8 million + RM46 million + RM25.6 million
VD= RM91.4 million
The value of the companys debt with low economic growth is the value of
the company because the company value is less (RM60 million and RM66
million) than the face value of the debt (RM68 million). In both other
economic states, the value of the debt is the face value of the debt.
So,
The expected value of the companys debt in one year without expansion
is:
VD= .30(RM60 million) + .50(RM68 million) + .20(RM68 million)
VD= RM18 million + RM34 million + RM13.6 million
VD= RM65.6 million
And the value of the companys debt in one year with expansion is:
VD= .30(RM66 million) + .50(RM68 million) + .20(RM68 million)
VD= RM19.8 million + RM34 million + RM13.6 million

VD= RM67.4 million

(b) Explain whether the companys stockholders would be better off with
or without expansion? If the expansion were financed with cash on hand,
how would it affect your answer?
Cost of financing:
RM91.4 million - RM73.4 million = RM18 million
Since the expansion will be entirely financed with equity at a cost of
RM16.8 million which is less than RM18 million, the expansion will create a
positive value for the stockholders. So the stockholders may be better off
with expansion.
It is a stronger signal that stockholders are not acting in their best interest
if the expansion is financed with cash on hand. If the company issues new
equity, the expected loss in stock value is shared proportionally by the
new investors, so the current stockholders will not bear the entire loss in
stock value alone. By expanding with cash on hand, current stockholders
are bearing the entire expected loss in stock value.

(c) How does the existence of financial distress costs and agency costs
affect Modigliani and Millers theory of capital structure in a world where
corporations pay taxes?
Modigliani and Millers theory with corporate taxes indicates that, since
there is a positive tax advantage of debt, the firm should maximize the
amount of debt in its capital structure. In reality, however, no firm adopts
an all-debt financing strategy. MMs theory ignores both the financial
distress and agency costs of debt. The marginal costs of debt continue to
increase with the amount of debt in the firms capital structure so that, at
some point, the marginal costs of additional debt will outweigh its
marginal tax benefits. Therefore, there is an optimal level of debt for every
firm at the point where the marginal tax benefits of the debt equal the
marginal increase in financial distress and agency costs.