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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