3. MM PROPOSITION, FIRM’S VALUE AND STOCK PRICES Let’s consider a firm who is in
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Question
3. MM PROPOSITION, FIRM’S VALUE AND STOCK PRICES
Let’s consider a firm who is initially an all-equity firm of n0 shares of outstanding stocks at a price p0, hence the firm’s value is simply VU = n0 p0. Now assume the firm is about to issue debts of a total value B to repurchase n1 shares of stock at price p0.
(b) Now assume there is corporate income tax at a rate t. On one hand, as discussed in class, the firm’s value now is
VL = VU + tB.
On the other hand, let p1 denote the stock price per share of the levered firm in this case, and the corresponding equity value is (n0 - n1)p1, while the value of debts is B as well. However, as in an efficient market, we should expect the stock price per share when the firm repurchases its stock to be different from p0, since the firm’s value, i.e. its future cash flows, is affected by the impact of tax shield. Therefore, we should expect that the price at which the firm repurchases its stock is p1, the price of the levered firm,
instead of p0. So we have B = n1 p1.
Given these information, derive an expression of p1 in terms of p0, B, t and n0. How the stock price of the levered firm is affected by its outstanding debts?
Explanation / Answer
Form the above information after leveraged firm the value is VL = VU + tB VU = n0 p0. Value of leveraged firm is (n0-n1)p1. Which is equal to (n0-n1)p1 = n0 p0 + tB p1 = (n0 p0 + tB)/(n0-n1) The stock prices will not change after leveraged firm. The changes in leverages can affect on Earnings per share not for the Market price per share.Related Questions
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