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M&M Proposition II Without taxes & bankruptcy costs
Lecture 17 M&M Proposition II Without taxes & bankruptcy costs
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Topics covered The proposition The formula The graph The implications
Numerical example Practice problem
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M&M Proposition II Assumptions: Perfect market No taxes
No bankruptcy costs M&M Proposition II: 1. A firm’s cost of equity depends on 3 factors: its weighted average cost of capital, cost of debt, and debt-equity ratio. 2. A firm’s weight average cost of capital will remain constant no matter what its debt-equity financing mix.
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The Formula RE = RA + [(RA – RD) x (D/E)] RE = required rate of return on equity (cost of equity) RA = required rate of return on firm’s assets RD = required rate of return on debt D = market value of debt E = market value of equity D/E = market value debt-equity ratio
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The Graph Required rate of return RE RA WACC RD D/E ratio
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The Implications The cost of equity is determined by 3 factors:
Cost of capital of the firm (WACC = RA) Cost of debt (RD) Debt-equity split (D/E) A firm’s cost of equity rises as financial leverage increases. A firm’s WACC is independent of changes in its capital structure.
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Numerical Example Millets and Multigrain Inc. has a weighted average cost of capital of 15%. It is currently financed entirely with common stock. Its current share price is $20, with 100,000 shares outstanding. The company’s managers is contemplating a bond issue of $1.2 million at 10% interest rate. The cash received from the bond issue will be used to repurchase 60,000 of the firm’s common shares. After the repurchase, the share price will remain at $20. According to the M&M Proposition II without taxes and bankruptcy costs, What is the cost of equity for the firm? What will be its WACC after the debt issue?
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Numerical Example (cont.): Calculation of RE
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Numerical Example (cont.): Calculation of WACC
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Less Talk, More Practice
HST n’ BC Inc. is financed by debt of $2 million and equity of $2 million. The company’s cost of debt is 8% and its weighted cost of capital is 16%. What is the company’s current cost of equity? What is the impact on the cost of equity if the company wants to change its debt-equity ratio to 0? 0.5? 1.5? 2? 2.5?
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Check answer to practice problem
We first write out the information given: D = $2,000,000 E = $2,000,000 RD = 0.08 WACC = RA = 0.16 The debt-equity ratio is: D/E = 2,000,000 / 2,000,000 = 1 M&M Proposition II without taxes and bankruptcy costs gives us the cost of equity formula: RE = RA + [(RA – RD) x (D/E)] Plugging in the numbers for RA, RD, and D/E, we get RE = [(0.16 – 0.08) x 1] = = 0.24 If the D/E = 0, we have RE = [(0.16 – 0.08) x 0] = = 0.16 If the D/E = 0.5, we have RE = [(0.16 – 0.08) x 0.5] = = 0.2 If the D/E = 1.5, we have RE = [(0.16 – 0.08) x 1.5] = = 0.28 If the D/E = 2, we have RE = [(0.16 – 0.08) x 2] = = 0.32
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End of Lecture 16
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