1. Lecture 16 M&M Proposition I Without taxes And Bankruptcy costs

2. Topic covered 1.Definitions of variables 2.Assumptions of the model 3.M&M Proposition I without taxes and bankruptcy costs. 4.Formula, Meaning and Implication 5.Numerical example 6.Practice problem

3. Definitions of variables 1.Capital structure = the mix of debt and equity financing in a firm 2.Unlevered firm = a firm that is financed entirely with equity, no debt 3.Levered firm = a firm that is financed with a mixture of debt and equity 4.EBIT = Earnings before interest and taxes 5.D = Dollar amount owed to Debtors 6.E = Market value of all shares in the company 7.V U = Value of an unlevered firm 8.V L = Value of a levered firm 9.R U E = Cost of equity for the unlevered firm

4. Assumptions 1.Perfect financial market 2.No taxes 3.No bankruptcy costs

5. M&M Franco Modigliani Merton Miller A theoretical model – Relationship between capital structure and firm value Question: If Debt/Equity mix  or  => Firm value  or  ?

6. M&M Proposition I -No taxes -No bankruptcy costs -Perfect market in which everyone and every firm can borrow and lend at the same rate -2 firms with the same EBIT stream -One firm financed by equity entirely – unlevered -One firm financed by equity and debt – levered M&M Proposition: -Both firms should have the same value -V U = EBIT/R U E = V L = D L + E L

7. Arbitrage opportunity Toaster #1: $20 Toaster #2: $30

8. Arbitrage Opportunity: V L < V U 50% Debt 50% Equity 100% Equity

9. Arbitrage Opportunity: V L > V U 50% Debt 50% Equity 100% Equity

10. Equilibrium 50% Debt 50% Equity 100% Equity

11. Equilibrium DL VL = EL + VU = EBIT / RU E

12. M&M I Formula V U = EBIT/R U E V L = D L + E L V L = V U = EBIT/R U E

13. Numerical Example Two firms have identical expected future stream of EBITs of $9,000 per year. Firm U is financed entirely by issuance of 1,000 shares at a cost of 15%. Firm L is financed by issuance of 500 shares and $30,000 in debt at an interest rate of 8%. (a)What is the value of Firm U? (b)What is the value of Firm L? (c)What is the value of equity in Firm L? (d)What is the share price in Firm U? (e)What is the share price in Firm L?

14. Numerical Example (cont.)

16. Practice or perish Quebec Inc. is an unlevered firm with 100,000 shares outstanding. Each Quebec share is currently selling at $15 per share, and the Quebec’s cost of capital is 20%. Ontario Corp. is a levered firm with 60,000 shares outstanding and $700,000 in debt. The cost of debt is 10% (a)What is the debt-equity ratio of Ontario Corp. if it has the same expected stream of EBIT as Quebec Inc.? (b)What is the expected EBIT per year for the two companies?

17. Check Answer: Information given: (a) D/E ratio for Levered Firm: V u = Share price x Number of shares = $15 x 100,000 = $1,500,000 V L = V U = $1,500,000 V L = D L + E L  E L = V L – D L  E L = $1,500,000 - $700,000 = $800,000 D L /E L = 700,000/800,000 = 0.875 (b) Cost of equity for Unlevered Firm: V U = EBIT/R U E => EBIT = V U x R U E = $1,500,000 x 0.2 = $300,000 per year Unlevered FirmLevered Firm Share price = $15Debt = $700,000 Number of shares = 100,000Cost of debt = 10% Cost of equity = 20%

18. End of Lecture 16 M&M Proposition I without taxes and bankruptcy costs