Question

The Chicago Delivery Inc. is an all equity firm. The company’s CFO is forecasting the following economic scenarios for the firm's cash flow before taxes. All cash flows are expected to be level perpetuities.

Recession                    Normal                        Expansion

EBIT                            25,000,000                  50,000,000                        100,000,000

           

(Probability)                 (40%)                          (40%)                           (20%)

The company’s cost of equity capital is calculated to be 10%. The company's CFO is recommending issuing $80,000,000 of debt to repurchase shares outstanding. Corporate tax rate is 40%. Using the above information, answer the following questions.

1. After issuing debt, the company president uses the Miller and Modigliani’s 1963 proposition (corporate taxes) to calculate the value of the company. What is the company’s total market value under this scenario?

2. The CFO does not agree with the president’s valuation. She contends that Miller and Modigliani’s 1963 proposition is not realistic. She believes the company’s total market value after the new debt issuance is much less at approximately $315 million. Discuss what explains the difference between the president’s and the CFO’s approaches?

Answer 1

Expected EBIT = 25000000*40%+5000000*40%+100000000*20% = 50000000$

Tax Rate = 40%

Cost of Equity = 10 %

Net Profit= 50,000,000-40% = 30,000,000

Value of Unlevered Firm = NP/Cost of equity = 30,000,000/10% = 300,000,000

Modigliani and miller Formula (with Taxes) Proposition 1

Value of firm = Value of Unlevered Firm + (Tax Rate * Value of Debt) Debt is assumed to be perpetual

= 300,000,000+ 80,000,000*40%

= 332,000,000

ANS VALUE = 332 million

b.) Value of the firm as per CFO's approach is 315 million which is 17 million less than the approach adopted by the president. CFO has valued the company on the basis of total market value after debt.

The approach adopted by the CFO is based on the market value of all its assets and Liabilities. Total Market value does'nt lays too much emphasis on the earning capacity of the firm.

whereas, the approach adopted by the president is based on the Income and earning capacity of the firm.