Summary

Modigliani and Miller theory

MM Proposition I:
• MM Proposition II (No Taxes)
• Leverage increases the risk and return to stockholders

• Rs = R0 + (B / SL) (R0 - RB)

• RB is the interest rate (cost of debt)

• Rs is the return on (levered) equity (cost of equity)
• R0 is the return on unlevered equity (cost of capital)
• B is the value of debt
• SL is the value of levered equity
 MM Propositions I & II (With Taxes)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
VL = VU + TC B

Proposition II (with Corporate Taxes)

Some of the increase in equity risk and return is offset by the
interest tax shield
RS = R0 + (B/S)×(1-TC)×(R0 - RB)

RB is the interest rate (cost of debt)

RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
2. Tool Manufacturing has an expected EBIT of $67,000 in perpetuity
and a tax rate of 35 percent. The firm has $130,000 in outstanding
debt at an interest rate of 8 percent, and its unlevered cost of capital is
15 percent. What is the value of the firm according to M&M
Proposition I with taxes? Should the company change its debt–equity
ratio if the goal is to maximize the value of the firm? Explain.
•ABC, Inc., a prominent consumer products firm, is debating whether to
convert its all-equity capital structure to one that is 35 percent debt. Currently,
there are 6,000 shares outstanding, and the price per share is $58. EBIT is
expected to remain at $39,6000 per year forever. The interest rate on new debt
is 8 percent, and there are no taxes.
a. John, a shareholder of the firm, owns 100 shares of stock. What is her cash
flow under the current capital structure, assuming the firm has a dividend
payout rate of 100 percent?
b. What will John’s cash flow be under the proposed capital structure of the
firm? Assume she keeps all 100 of her shares.
 Pay out Policy

Dividend pay outs Share repurchase

1. The company with a the common equity account shown here has
declared a stock dividend of 15 percent when the market value of its
stock is $57 per share. What effects on the equity account will be
distribution of stock dividend have?

Common stock ($10 par 435,000

value)

Capital surplus 2,15,000

Retained earnings 5,873,000
Total owner’s equity 8,458,000
Suppose the stock of Host Hotels & Resorts is currently trading for $20
per share.
a. If Host issued a 20% stock dividend, what will its new share price be?
b. If Host does a 3:2 stock split, what will its new share price be?
c. If Host does a 1:3 reverse split, what will its new share price be?
With a 20% stock dividend, an investor holding 100 shares receives 20
additional shares. However, since the total value of the firm’s shares is
unchanged, the stock price should fall to:
A) Share price = $20 × 100 / 120 = $20 / 1.20 = $16.67 per share.

B).A 3:2 stock split means for every two shares currently held, the investor
receives a third share.
• Share price = $20 × 2/3 = $20/ 1.50 = $13.33 per share.

C). A 1:3 reverse split implies that every three shares will turn into one share.
Therefore, the stock price will rise to:
• Share price = $20 × 3 / 1 = $60 per share.
2. Flychucker corporation is evaluating an extra dividend versus share
repurchase. In either case $6,300 would be spent. Current earnings are
$2.60 per share and the stock currently sells for $51 per share. There are
1,500 shares outstanding. Ignore taxes and other imperfections in
answering parts the following:
a. Evaluate two alternatives in terms of the effect on the price per share
of the stock and shareholder wealth.
 Raising capital
• Left Turn, Inc., has 120,000 shares of stock outstanding. Each share is worth
$94, so the company’s market value of equity is $11,280,000. Suppose the
firm issues 25,000 new shares at the following prices: $94, $90, and $85.
What will the effect be of each of these alternative offering prices on the
existing price per share?
 Raising capital
• Meera owns 300 shares of ABC corporation and the
shares are trading at $20 each. The company announces
a rights issue in the ratio of 1 for 5. The subscription price
for the rights issue is $12. Calculate the following
• Value of portfolio before rights issue
• Value of portfolio after rights issue
• Price per share post issue
Leasing

• ABC Entertainment is considering buying a machine that costs

$2,80,000. The machine will be depreciated over six years by the straight
line method and will be worthless at that time. The company can lease
the machine with year-end payments of $ 65,000. The company can
issue bonds at an interest rate of 10%. If the corporate tax rate is 35%,
a) Should the company buy or lease? Comment.

b) Assume in the above problem, ABC entertainment pays no taxes, what

range of lease payments does the lease have a positive NPV for both parties?
 Working capital management

• Operating cycle = Receivable period + Inventory period

• Cash cycle = Operating cycle – Operating cycle

• Here are some important figures from the budget of Nashville Cornell,Inc., for the second quarter of
2016:
  April May June
Credit sales $ 6,01,900 $ 6,27,300 $ 6,93,790
Credit purchases 2,32,850 2,77,900 3,17,380
Cash disbursements      
Wages, taxes, and expenses 62,964 76,364 79,670
Interest 18,058 18,058 18,058
Equipment purchases 1,31,400 1,44,200 -

The company predicts that 5 percent of its credit sales will never be collected, 35 percent of its sales will be
collected in the month of the sale, and the remaining 60 percent will be collected in the following month. Credit
purchases will be paid in the month following the purchase. In March 2016, credit sales were $332,640, and credit
purchases were $247,100. Using this information, complete the following cash budget:

  April May June

Beginning cash sales $ 4,43,500
Cash receipts  
Cash collections from credit sales
Total cash available
Cash disbursements
Purchases
Wages, taxes, and expenses
Interest
Equipment purchases
Total cash disbursements
Ending cash balance
 Credit and inventory management

• NPV of switching the policy (Credit management)

• NPV = PV of benefit of switching – Cost of switching
• Credit period = One month
• If P = price/unit
• V = variable unit/unit
• Q = quantity sold before switching
• Q1 = Quantity sold after switching
• R = Monthly rate of return
Then
• NPV = (P-V) (Q1-Q)/(R) – [(PQ+V(Q1-Q))]
 Inventory management

• The EOQ model minimizes the total inventory cost

• Total carrying cost = (average inventory) x (carrying cost per unit) =
(Q/2)(CC)
• Total restocking cost = (fixed cost per order) x (number of orders) =
F(T/Q)
• Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) +
F(T/Q)