Question

Syntonic Limited is an Australian-based company subject to the classical tax system, with a corporate tax rate of 30%. Historically, the company has been successful with its projects and currently generating earnings before interest and taxes (EBIT) of $8 million per year, and this level of earnings is assumed to continue forever. However, due to increased competition in its markets, many of its customers are shifting to new service providers. All of the company’s finance has come from shares issued at a cost of 18%. Due to a boardroom dispute, the company is proposing to buy back shares from a group of dissatisfied shareholders by borrowing $28 million at an interest rate of 15%.

(i) What is the value of the company with an all-equity capital structure? [

(ii) According to Modigliani and Miller (MM) approach with corporate taxes, what is the value of the company if it borrows the money and uses it to repurchase shares?

(iii) Explain the financial distress risk of Syntonic Limited after it had borrowed the money to buy back its shares?

Answer 1

1) Statement showing Value of the company
EBIT	80,00,000
Less: Interest on debentures
Earnings available for Equity share holder	8,000,000
Total cost of capital	18%
Value of the company ( V)= EBIT/ Cost of capital	$44,444,444.44

2)

According to MM approach, Value of a firm can be calculated as follows: Value of Unlevered firm (Vu) = EBIT K (1 – t) , Where EBIT = Earnings before interest and taxes, Ko = Overall cost of capital, D = Value of debt capital, t = Tax rate. Value of levered firm (Vl) = Value of Unlevered firm + Debt (tax )

EBIT	$80,00,000

Cost of Capital 18%

Tax rate 30%

Value of Unlevered company = (EBIT) /Cost of capital *(1-t) $ 31111111

Value of Comapny = Unlereved value + Debt tax rate = 31111111+ 84000000 = $ 39511111

3)

According to MM approach , for any firm in a given risk class, the cost of equity is equal to the constant average cost of capital (Ko) plus a premium for the financial risk, which is equal to debt - equity ratio times the spread between average cost and cost of debt. Ko will not increase with the increase in the leverage, because the low - cost advantage of debt capital will be exactly offset by the increase in the cost of equity as caused by increased risk to equity shareholders.