COMM370 Alejandra Medina

1
Practice for Lecture 12-13: Modigliani-Miller Propositions

Question 1. Prove Modigliani-Miller proposition 1 with corporate taxes. As part of your
answer, clearly state the underlying assumptions, explain the intuition underlying the proof,
and conceptually interpret the meaning of the proposition.

Note: you should be able to formally prove MM 1 & MM2 as we did in class.


Question 2. Levered Inc. and Unlevered Inc. are identical in every respect except for capital
structure. Both companies expect to earn $150 million in perpetuity, and both distribute all of
their earnings as dividends. Levereds perpetual debt has a market value of $300 million and
the required return on its debt is 7%. Levereds stock sells for $100 per share, and there are 5
million shares outstanding. Unlevered has 8 million shares outstanding worth $90 each.
Unlevered has no debt. These firms operate in the Modigliani-Miller world with no taxes. How
can you take advantage of this scenario?


Question 3. Northrop has 80 million shares worth $10 per share and no debt. Its cost of
capital is 5%. It has a perpetual random CF with mean $40 million and it pays no taxes.
Northrop plans a leveraged recapitalization, in which it will issue $300 million in perpetual
debt at an interest rate of 2% per year and use the proceeds to repurchase shares. The firm
operates in the Modigliani-Miller world with no taxes.

a) What are Northrops firm value, cost of equity, and WACC before the recapitalization?

b) What are Northrops firm value, equity value, debt value, cost of equity, and WACC after
the recapitalization? Compare you results to those in a) and interpret the differences.

c) What happens with Northrops equity values and share price at the time of the
announcement but before the recapitalization is executed?

d) How many shares can Northrop repurchase and how many shares outstanding are left after
the transaction?


Question 4. Vortex has 70 million shares outstanding which trade at $6 per share and
perpetual debt with market value of $500 million. The interest rate on its debt is 2% per year
and its cost of equity is 7.143% per year. It has a perpetual (before tax) random CF with mean
$60 million and it pays taxes at a 40% tax rate. Vortexs management will announce tomorrow
its decision to issue the amount of equity necessary to immediately retire all of the firms debt
outstanding. The announcement will also convey that Vortex will maintain its new all-equity
capital structure in the future. The firm operates in the Modigliani-Miller world with taxes.

a) What is the market value of Vortexs assets and what is Vortexs WACC before the
announcement?

COMM370 Alejandra Medina
2
b) What is the market value of Vortexs assets and what is Vortexs WACC after equity is
issued and debt retired, that is, its value with the new all-equity capital structure?

c) What is Vortexs equity value and share price just after the announcement, but before the
new equity is issued and debt is retired?

d) How many shares will Vortex issue in order to retire all of its debt? What is the new
number of shares outstanding after the transaction?

e) What is Vortexs share price after debt is retired?

f) Will the change in capital structure benefit the original shareholders?


Question 5

Based on the graph please answer the following questions:

a) Why the return on the equity increases with leverage always? Explain in detail.

b) Why in a M&M world without taxes WACC does not change with changes in leverage?
Explain in detail.

c) Why in a M&M world with taxes WACC decreases when leverage increases? Explain in
detail.

From the book RWJR, Chapter 16:

16.1
16.4
16.5
16.8
16.9
16.10
16.11
16.13
16.14
16.15
16.17
16.18
16.20
16.21
16.22
16.24
16.25