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Case

Suppose you are a financial analyst of ABC Company which was 100% equity financed with net worth of Rs. 10 million and Weighted Average Cost of Capital of 22%. 
Management of the company has decided to change its capital structure by adding Rs. 4 million in debt at 14% cost of debt. Net income and cost of equity were Rs. 2,040,000 and 16.4% respectively after this restructuring. Moreover, Tax rate is 30%.


Required
:

  1. Keeping in view the Modigliani & Miller (M&M) theorem, you are required to calculate:

                             i.      WACC of levered firm by ignoring tax.

                              ii.      WACC of levered firm by considering tax.

 

  1. On the basis of above calculation you are required to prove that M&M proposition are applied or not. Justify your answer with logical reasoning.

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Replies to This Discussion

2 part ka answer kya ho ga.?

2nd part ka answer hy:-

 

The M&M proposition is applicable as WACC is less when the company uses debt  in its capital structure due to nonpayment of tax on interest payments

mgt201 gdb current solution 2013

E = 10000000
D = 4000000
V= 10000000 + 4000000 
V= 14000000
re= 16.4 %
rd= 14 %
Tc= 30%

WACC of levered firm by ignoring tax:
WACC = E / V * Re + D / V * Rd
WACC = 2040000* 0.164 + 4000000 * 0.14
WACC of levered firm by considering tax:
WACC = E / V * Re + D / V * Rd * (1 – Tc)
WACC = 2040000* 0.164 + 4000000 * 0.14*(1-0.30)

answer batae

mujy E/V KI CONFUSION HO REHE HY aap ne kesy calculate ki hy tariq

in dono k answers ye aty hain tariq is it correct

894560

726560

E=NI/Re

tariq bhaiii

jonsa marzi solution pakar lo and copy past kar do jitna time rah gaya hai ab tou yahi karna paray ga...

 

tariq bhai answer tu pura krr do 

buddy answer share kery

In summary, the MM I theory without corporate taxes says that a firm's relative proportions of debt and equity don't matter; MM I with corporate taxes says that the firm with the greater proportion of debt is more valuable because of the interest tax shield.

MM II deals with the WACC. It says that as the proportion of debt in the company's capital structure increases, its return on equity to shareholders increases in a linear fashion. The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company's stock. However, because the company's capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction and thus concludes that changes in the debt-equity ratio do affect WACC. Therefore, a greater proportion of debt lowers the company's WACC.

I THINK NOW IT IS CLEAR

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