Question

AirCnC plans to decrease its financial leverage by issuing equity and using the proceeds to repurchase its debt. In a Modigliani and Miller world with no corporate taxes what is the most likely effect of this transaction?

Answer 1

In Modiglian Miller approach, there is a belief that the value of levered company would be equal to the value of unlevered company.

So, when it is planning to decrease the financial leverage by issuances of equity and using the proceeds to repurchase the debt, it will mean that it will not be resulting into any of the considerable changes and the value of the organisation which was earlier will be similar to the value of the organisation which is now after the transaction has occurred.

So, it can be emphasized that in a tax free world, under ModiGliani Miller approach, there are no transaction cost involved and the value of a company who have financial leverage and the value of company who is completely financed with equity will be having similar values and they will not be having any additional advantage so even if it is cutting off into its leverage by issuance of equity, it will not leading to any subsequent improvement into the overall market capitalisation of the company.