Kyle Corporation is comparing two different capital structures, an all-equity pl
ID: 2720954 • Letter: K
Question
Kyle Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Kyle would have 780,000 shares of stock outstanding. Under Plan II, there would be 530,000 shares of stock outstanding and $10 million in debt outstanding. The interest rate on the debt is 10 percent, and there are no taxes.
1. Use M&M Proposition I to find the price per share of equity.
Share price________
2. What is the value of the firm under Plan I?
Value of the firm________
3. What is the value of the firm under Plan II?
Value of the firm_________
Explanation / Answer
For unlevered firm
Total Number of equity = 780,000
For levered firm
Total number of equity = 530,000
Value of debt = $10,000,000
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 10% interest per annum.
By using M&M Proposition I, price of equity is calculated below:
Price of equity = $10,000,000 / (780,000 – 530,000)
= $40.00
Hence, by using M&M Proposition I, price of equity is $40.00.
Value of firm under Unlevered firm = $40.00 × 780,000
= $31,200,000
Hence, value of unlevered firm is $31,200,000.
Value of levered firm = ($40 × 530,000) + $10, 0000,000
= $21,200,000 + $10,000,000
= $31,200,000
Hence, value of levered firm is $31,200,000
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