Discussion Participation: Mini Case Question c) part (1) Paulina Jaswiec

Chapter 17 and Lyons Solar Technologies Mini Case

A) Who is M&M?

Franco Modigliani and Merton Miller studied capital structure and developed their own M&M Theorem (impact of debt on Firm Value). This theorem explained how the “value of the firm is unaffected by how the firm is financed (investopedia, 2012).” They highlighted two firms identical in structure except: Firm A- was financed by equity only, and Firm B was financed both by equity and debt. Even though the capital structures are different (Firm A to Firm B) they both hold the same value. (Referenced from book: Financial Management Theory and Practice- Chapter 26: Analysis of Capital Structure Theory. Page 996) (Brigham & Ehrhardt, 2011) “The basic M&M proposition is based on the following key assumptions:

No taxes (this is the most important for our mini case) No transaction costs No bankruptcy costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same

information No effect of debt on a company's earnings before interest and taxes”

Position 1: net operation income (EBIT) on a constant rate (rsu)

= EBIT = EBIT (Brigham & Ehrhardt, 2011)

WACC rsu

“Implies the following statements 1. The weighted cost of capital, WACC , is completely independent of a firm’s capital structure. 2. Regardless of the debt a firm uses, its WACC is equal to the cost of equity that it would have if

it used no debt. “

(Retrieved from web- Wikipedia: Modigliani – Miller Theorem. Last undated January 2007)

Position 2: cost of equity or

rsl= rsu + risk premium rsu + (rsu - rd ) (D/S)

Cost of equity (risk class) 1. “The difference between an unlevered firm’s cost of debt and equity 2. And.. The amount of debt used.”

(Retrieved from web- investopedia: The Complete Guide to Corporate Finance- Financial Leverage And Capital Structure Policy - Modigliani And Miller's Capital Structure Theories)

B) Assumptions made after being give the data:

If NO taxes (stays the same), and no matter what the changes to in the debt percentage company L and U, VALUE stay the same.

1) For Firms U & L- Make a chart with the following: V, S, r, WACC

Discussion Participation: Mini Case Question c) part (1) Paulina Jaswiec

rsl= rsu + risk premium = (14% )+ (6%) x (0.39) = 16% Cost of Equity for firm L note: 14% Cost of Equity for firm U

WACC= [(D/V)( rd)] + [(S/V)( rs)] = (2.24%) + (11.8%) = 14% Weight Average Cost of Capital

Firm U Firm LDebt Financing NO Debt Financing Some Debt Financing

Debt $ 0 $ 1,000,000EBIT $ 500,000 $ 500,00

rd (debt outstanding at cost) 0% 8%

Rsu (cost of equity) 14% 0%

Taxes $ 0 $ 0

Value of firm

EBIT/ Rsu$ 3,571,429 $ 3,571,429

Value of Equity $ 3,571,429 $ 2,571,429

Without taxes for:

rd is always 8%WACC is always 14%V is always $ 3.5

D S Rs D/V0 $ 3.50 14 % 0 %0.5 $ 3.00 15 % 14.29 %1 $ 2.50 16.4 % 28.57 %1.5 $ 2.00 18.5 % 42 %

2) Graph the relationship between Firm U & L. Find the following (WITHOUT TAXES)

Capital costs and Leverage: D/V Relationship between V & D

0% 10% 20% 30% 40% 50% 60%0%

5%

10%

15%

20%

25%

rs WACC rd

CC

Cost of Capital

D/V

Debt/ Value Ratio

Discussion Participation: Mini Case Question c) part (1) Paulina Jaswiec

c) Using the data given in part B, but now assuming that firms L and U are both

subject to a 40 percent corporate tax rate, repeat the analysis called for in B(1)

and B(2) under the MM with-tax model.

With taxes for:

rd is always 8%

[rd x (1 –T)] is always 4.8%

D S Rs D/V V WACC0 $ 2.14 14 % 0 % $ 2.14 14 %0.5 $ 1.84 14. 98 % 21.37 % $ 2.34 12.8 %1 $ 1.54 16.34 % 39.38 % $ 2. 54 11.8 %1.5 $ 1.24 18.35 % 54.74 % $ 2.74 10.93 %

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%0%

2%

4%

6%

8%

10%

12%

14%

16%

rs WACC rd x (1-T)

CC

Cost of Capital

D/V

Debt/ Value Ratio