Question

Let D and E denote the market values of the outstanding debt and equity of company A. A’s 1,000 shares sell for £50 apiece. The company has also borrowed £25,000. The company borrows an additional £10,000 and pays the proceeds out to shareholders as a special dividend of £10 per share. What will A’s equity be worth after the special dividend is paid? Explain how a change in capital structure affects shareholders. Under the Modigliani and Miller Theory any combination of securities is as good as another. Discuss.

Answer 1

Part 1	Here, first we need to understand the meaning of special dividen,
	A special dividend, also referred to as an extra dividend, is a non-recurring, “one-time” dividend distributed by a company to its shareholders. It is separate from the regular cycle of dividends and is usually abnormally larger than a company’s typical dividend payment.
	Impact of special dividend on share price:-
	Special dividends exert the same effect as a cash dividend on share prices. In the given Question, a stock that is currently trading at 50 pound one day before the Ex. Dividend Date. The special dividend declared is 10 pound per share.
	Theoretically, on the ex-dividend date, the stock should decrease by 10 pound and trade at 40 pound. With that said, the stock might actually be higher or lower than 40 Pound on the ex-dividend date, depending on investor sentiment regarding the special dividend.
	So, theoritacly, after the payment of special dividend, A's equity worth will be (1000*40)= 40000 pound.
Part 2	Here, we need to explain, how change in capital structure affects the shareholders.
	Capitalization structure (more commonly called capital structure) simply refers to the money a company uses to fund operations and where that money comes from. Capital can be raised either through the acquisition of debt or through equity. Financing comes from the sale of stock to shareholders. Debt can come from many sources, such as bank loans, personal loans and credit card debt, but it must always be repaid at a later date, usually with interest.
	The composition of capital structure impacts on the shareholders' value since it influences the cost of capital invested in the company. If the Return on investment remains equal, a rise in the cost of capital will cause a decrease in the company's profitability and in shareholders' wealth.
	If the proportion of debt in capital structure increases above a certain level, the adding cost of debt includes a higher bankruptcy cost, higher financial distress problem and more conflict between shareholders and debt holders, thus damaging the firm performance.
	The standard theory is that additional debt increases the value of the firm's shares because the tax shield stemming from the interest deduction accrues to the shares, not the debt. At the same time, as the amount of debt increases, the agency costs of debt increase and the expected costs of bankruptcy increase. At some point, the two offset each other and the capital structure is optimal from the shareholders' viewpoint. The empirical problem is that the marginal tax rate is hard to measure, and agency costs and expected bankruptcy costs are not observable.
	Conclusion:- yes, capital structure affects the shareholders wealth
Part 3	Under the Modigliani and Miller Theory any combination of securities is as good as another. Discuss.
	The fundamentals of the Modigliani and Miller Approach resemble that of the net operating income approach
	Modigliani and Miller advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component in the financing mix has no bearing on the value of a firm.
	The Modigliani and Miller Approach further states that the market value of a firm is affected by its operating income, apart from the risk involved in the investment. The theory stated that the value of the firm is not dependent on the choice of capital structure or financing decisions of the firm.
	The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix of debt and equity) is the same as the value of an unleveraged firm (a firm that is wholly financed by equity) if the operating profits and future prospects are same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.
	Conclusion:- Yes under Modigilani and miller approach, any combination of any securities is as good as another.