Skim Milk and Part Whole Milk are identical firms except that Skim is more lever

Question

Skim Milk and Part Whole Milk are identical firms except that Skim is more leveraged than Part Whole. The probability of a recession is equal to the probability of an expansion. If recession occurs, each Firm will have EBIT of $0.5 million next year. If expansion occurs, each firm will have EBIT of $3 million next year. Part Whole’s debt interest obligation requires $0.5 million in payments. Skim has more debt, its interest obligation is $1.5 million. Assume Skim’s WACC is 10%, Whole Milk’s debt holders require 3% rate of return, Skim’s debt holders require 5% in return. Assume one period and no taxes.

a) What’s the value of equity for each firm?

b) Use e, a, d of Part Whole or Skim to show MM proposition two (e =a+D/E *( a –d)). Assume market risk premium is 5%.

Explanation / Answer

WACC

=

E

×

re

+

D

×

(1 t)

×

rd

+

P

×

rp

(E+D+P)

(E+D+P)

(E+D+P

Where:

E              =             Market value of equity

D             =             Market value of debt

P             =             Market value of preferred stock

re            =             Cost of equity

rd            =             Cost of debt

rp            =             Cost of preferred stock

t              =             Marginal tax rate

The market values of equity, debt, and preferred should reflect the targeted capital structure, which may be different from the current capital structure. Even though the WACC calculation calls for the market value of debt, the book value of debt may be used as a proxy so long as the company is not in financial distress, in which case the market and book values of debt could differ substantially. Multiplying the debt term in the WACC equation by (1t) captures the benefit of the tax shield arising from interest expense.

WACC

=

E

×

re

+

D

×

(1 t)

×

rd

+

P

×

rp

(E+D+P)

(E+D+P)

(E+D+P

Financial Leverage And Capital Structure Policy - Modigliani And Miller's Capital Structure Theories

Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends.
The basic M&M proposition is based on the following key assumptions:

WACC

=

E

×

re

+

D

×

(1 t)

×

rd

+

P

×

rp

(E+D+P)

(E+D+P)

(E+D+P

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