Question

A firm is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 200,000 shares of stock outstanding. Under Plan II, there would be 150,000 shares of stock outstanding and $2.15 million in debt outstanding. The interest rate on the debt is 5 percent and there are no taxes. a. Use M&M Proposition I to find the price per share. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b. What is the value of the firm under each of the two proposed plans?

Answer 1

Answer:

Consider the following calculation

Explanation:

For unlevered firm

Total Number of equity = 200,000

For levered firm

Total number of equity = 150,000

Value of debt = $2,150,000

Under M&M Proposition I, that is there is no rule of tax in economy. So there is not benefit of tax shield on the debt securities. So debt will be same as equity. Only deference between debt and equity M&M Proposition I is the debt has obligation to pay 5% interest per annum.

By using M&M Proposition I, price of equity is calculated below:

Price of equity = $2,150,000 / (200,000 – 150,000)

                       = $43.00

Hence, by using M&M Proposition I, price of equity is $43.40.

Value of firm under Unlevered firm = $43.00 × 200,000

                                                         = $8,600,000

Hence, value of unlevered firm is $8,600,000.

Value of levered firm = ($43 × 150,000) + $2,150,000

                              = $6,450,000 + $2,150,000

                              = $8,600,000

Hence, value of levered firm is $8,600,000