DAR Corporation is comparing two different capital structures, an all-equity pla

Question

DAR Corporation 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 155,000 shares of stock outstanding. Under Plan II, there would be 105,000 shares of stock outstanding and $1.33 million in debt outstanding. The interest rate on the debt is 6 percent and there are no taxes

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.)

What is the value of the firm under each of the two proposed plans? (Do not round intermediate calculations and round your answers to the nearest whole dollar amount, e.g., 32.)

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.)

Explanation / Answer

Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1:

With the above assumptions of “no taxes”, the capital structure does not influence the valuation of a firm. In other words, leveraging the company does not increase the market value of the company. It also suggests that debt holders in the company and equity share holders have the same priority i.e. earnings are split equally amongst them.

Proposition 2: I

t says that financial leverage is in direct proportion to the cost of equity. With increase in debt component, the equity shareholders perceive a higher risk to for the company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost of equity. A key distinction here is that proposition 2 assumes that debt share holders have upper-hand as far as claim on earnings is concerned. Thus, the cost of debt reduces

Solution

In the given problem, EPS and cost of euqity not avaialble

So, EPS =25 per share (asssumed)

Cost of equity =10% (assumed)

1. Value of share =25/10%

=$ 250 per share

2.value of the firm under each of the two proposed plans

Plan-I

a) no of shares =155000

b) Value per share =250

c) value of firm =$ 38,750,000

Plan-II

a) no of shares =105000

b) Value per share =250

c) value of firm =$ 26,250,000

d) value of debt= $ 1,330,000

e) Value of the firm =$27,580,000

Related Questions

Navigate

• Browse (All)
• Browse D
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.