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Firms U and A are similar except that firm U is unlevered, while firm A is...

Firms U and A are similar except that firm U is unlevered, while firm A is a levered and has 5% Debt of 20% in its total capital structure amount of OMR 1,000,000.
​Assume that the corporate tax rate is 40%; net operating income is 20% of total fixed assets and the cost of equity of unlevered firm is 10%. Total fixed assets amount OMR 700,000.
​As finance student, by following Modigliani-Miller Approach estimate the value of the unlevered firm (U) and levered firm (A) and also compute overall cost of capital of levered firm.
​Suppose that if the firm A increases its debt amount to 50% of its total capital structure, then what would be the new equity value of levered firm A, and new cost of equity of levered firm A

Solutions

Expert Solution

Part(a)

Particulars Firm - U Firm - A
(Unlevered) (Levered)
Capital 1000000 1000000
5% Debt (1000000*20%) 200000
Net operating income(20% of fixed asset 700000) 140000 140000
Tax rate 40% 40%
Net operating income(20% of fixed asset 700000) 140000 140000
Less:Interest 10000
Net profit before tax 140000 130000
Less:Tax @40% 56000 52000
Profit available for distribution 84000 78000
Cost of equity 10% 9.17%**
Market value of firm (profit available for distribution/cost of equity) 840000 850906
Total value of firm (Debt+market value of firm) 840000 1050906

Overall cost of capital of levered firm

Weighted Average Cost of Capital=5%*(200000/1200000)+10%*(1000000/1200000)
0.091667
9.17%

Part (b)

Increase in Debt to 50% by Firm -A
Particulars Firm - A
(Levered)
Capital 1000000
5% Debt (1000000*50%) 500000
Net operating income(20% of fixed asset 700000) 140000
Tax rate 40%
Net operating income(20% of fixed asset 700000) 140000
Less:Interest 25000
Net profit before tax 115000
Less:Tax @40% 46000
Profit available for distribution 69000
Cost of equity 35%
Market value of firm (profit available for distribution/cost of equity) 197143
Total value of firm (Debt+market value of firm) 697143

New cost of capital

Weighted Average Cost of Capital=5%*(500000/1500000)+10%*(1000000/1500000)
0.35
35%

ekkarill92 answered 1 year ago
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