Question

Charles Carmichael Industries (CCI) is a large telecommunications firm. It is expected to generate an EBIT of $50 million per year in perpetuity and to pay out 100% of its after-tax cash flows as dividends. CCI’s expected cost of capital, as an unlevered firm, is 10%. The expected cost of any debt CCI issues is 5%. What are the market value of CCI, the market value of CCI’s debt, and the market value of CCI’s equity under the following scenarios? (In each part, please assume that the appropriate versions of Modigliani and Miller’s Proposition 1 and 2 hold.) (a) CCI remains unlevered and the corporate tax rate equals 0%. (b) CCI raises $100 million in debt and buys back $100 million in common stock and the corporate tax rate equals 0%. (c) CCI remains unlevered but the corporate tax rate equals 40%. (d) CCI raises $100 million in debt and buys back $100 million in common stock and the corporate tax rate equals 40%. (e) When CCI was unlevered, it had 300 million shares outstanding. How did CCI’s market value of equity per share change between parts (c) and (d)?

Answer 1

a.)

where Rassets, which measures the required return on the firm’s assets, is the required return on equity for an unlevered firm, which we are told is equal to 10%.

b.)

With corporate rates, M&M tell us that:

Since the corporate tax rate is 0%, however, the present value of the tax shield is $0. In addition, since the debt was just issued, it must have a market value of $100 million.

In M&M’s world without corporate taxes, changes to capital structure do not impact firm value, but do impact how that value is divided between stockholders and bondholders.

c.)

In part (a), the shareholders received the full value of EBIT. In part (c), with a corporate tax rate of 40%, the shareholders only receive 60% of EBIT. Therefore, relative to the answer in part (a), firm value falls by the present value of the firm’s tax obligations.

Where did the other $200 million go? To the government, where we assume it does not differentially benefit CCI’s shareholders or bondholders.

d.)

Again, with corporate rates, M&M tell us that

Since the debt was just issued, it must have a market value of $100 million. Therefore, all of the increase in the market value of CCI accrues to the shareholders.

e.)

As discussed in lecture, when CCI announces this restructuring—but before it can actually issue the debt or buy back the equity—the total market value of equity should increase from $300 million to $340 million, making all of the shareholders better off. Since there were 300 shares outstanding, the price per share rises from $1.00 to $1.13 (= $340 / 300). When CCI uses the $100 in debt to buy back shares, it is able to buy back 88.235 of the 300 shares outstanding. The remaining 211.765 shares will still trade at $1.13 per share, for a total market value of equity of $240 million. All of CCI’s shareholders benefit from the lower tax obligation.