6. Assume M&M; holds. Your firm has a total enterprise value of $3b. Its publica

Question

6. Assume M&M; holds. Your firm has a total enterprise value of $3b. Its publically traded equity has a market value of $2b and its publically traded debt has a market value of $1b. The expected return on the firm's equity is 15% and the expected return on the firm's debt is 9%. The equity beta is 1.1 and the debt beta is 0.5. The risk free rate is 3%. Assume there are no taxes. If you own a portfolio consisting of all of this company's debt and equity, what is the portfolio's expected return? . Now assume your firm issues an additional $1b in equity and pays back all of its debt. As a result, you now own $3b worth of the company's equity and zero debt. In an M&M; world, how will this change affect the firm's WACC, the expected return on the firm's new assets? * You decide to sell half of your stake in the company, how does this affect your expected return? Under the new capital structure, how is the return on equity affected?

Explanation / Answer

(a). Here if we have have a portfolio and if we calculate return on that. then we are actually calculating WACC.

E(rp) = We * Ke + Wd * Kd = 0.667 * 15% + 0.333 * 9% = 13.002%.

SO the expected return on a portfolio of debt and equity is 13%.

By other approach where we find beta of portfolio = 0.93 and then apply CAPM to find expected return on market through cost of equity = 13.9%. And then apply CAPM for the whole portfolio we get expected return on portfolio = 13.13%.

(b). Now if debt is all paid and additional $1bn equity is issued this will increase the WACC to 15%, as now debt is 0. And assuming the cost of equity remains as it is we can say the new WACC should be 15%. But actually it should rise even more, as because as the amount of equity keeps rising up the expected risk for an investor is higher than previous and so it's expeccted that the return on that equity should be higher than before now. BUT as nothing has been specified we simply say WACC would be higher than 13% and is expected to be 15% or more.

(c). This would reduce my return to half. As the expected return on equity is based on per share basis, which how is stake is defined as well. If I sell half of my stake in a firm then this is reducing my shares to half which I initially had. So the overall return earned by me will be halved but return on each share will remain as it is.

(D). As I said earlier the expected return in new capital structure should go up but the return on equity should actually decrease under this new capital structure as the company has now increased its equity so all the shareholders are at increased risk which should increase their return but at the same time,

Return on equity = Net income / total equity. As the total equity has increased, hence ROE should go down.

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