Capital Structure, MM Theory and a small case assignment 1 You own 100 shares of ABC corp. that is into pipe manufacturing business. ABC corp. currently has 10000 shares outstanding. The firm has a total asset size of ₹ 1 million entirely funded by equity. The firm’s EBIT is expected to be ₹ 100,000 forever and the firm pays out all earnings as dividends. The cost of borrowing in the market is 8%. Assume perfect market conditions of MM world (no tax, same borrowing cost etc.) 1. Currently, what is ABC corp. stock price? [1 mark] 2. Suppose, ABC corp. comes up with a new idea to buy back shares from the market to replace equity. The idea is to add ₹ 350,000 worth of debt. How many shares will be bought back? [1 mark] 3. What is the new stock price after the repurchase? [1 mark] 4. Suppose, the firm has moved from zero debt to having debt as mentioned in question 2. You still own 100 shares after the restructure. Though the firm has debt now, your preference is still the old unlevered earnings. Show using home made leverage how you can continue to earn the same earnings that you had before the restructure, even though you currently own shares of the levered firm: [2 marks] 5. Draw the market value balence sheet of the firm before and after the restructure. [2 marks] 6. Suppose, the taxes are now 25%. As per question 2 , the firm has just announced the restructure. Redraw the market value balance sheet on the day of announcing the new debt. [1 mark] 7. In question 6 , what is the new stock price? [ 1 mark] 8. Suppose, the firm has raised the debt and repurchased shares. How many shares would it repurchase now? [1 mark] 9. In question 8 , after the repurchase, redraw the market value balance sheet. [1 mark] 10. What is the new share price once the repurchase is complete? [ 1 mark] 11. What is your overall learning in this exercise? [3 marks]
In this exercise, we’ll explore the concept of capital structure, the Modigliani-Miller (MM) theory, and the impact of leverage on a firm’s stock price and balance sheet. We’ll use a hypothetical case of ABC Corp., a pipe manufacturing company, to illustrate these concepts. Please note that all calculations are simplified, assuming perfect market conditions with no taxes and the same borrowing cost.
1. Current Stock Price:
ABC Corp. has 10,000 shares outstanding and total assets of ₹1 million, entirely funded by equity. The EBIT is ₹100,000, and all earnings are paid as dividends. In a no-tax, MM world, the stock price is calculated as the present value of perpetual dividends discounted at the cost of equity:
Stock Price = EBIT / Cost of Equity Stock Price = ₹100,000 / 0.08 Stock Price = ₹1,250,000
2. Shares Bought Back with Debt:
ABC Corp. plans to buy back ₹350,000 worth of shares with debt. To calculate the number of shares to be repurchased, we divide the debt amount by the current stock price:
Number of Shares Repurchased = Debt Amount / Stock Price Number of Shares Repurchased = ₹350,000 / ₹1,250,000 Number of Shares Repurchased = 280 shares
3. New Stock Price after Repurchase:
After repurchasing 280 shares, the new number of shares outstanding will be 10,000 – 280 = 9,720 shares. The new stock price is calculated as:
New Stock Price = EBIT / Cost of Equity New Stock Price = ₹100,000 / 0.08 New Stock Price = ₹1,250,000
4. Home-made Leverage:
Even though the firm now has debt, you can still replicate the old unlevered earnings by following a home-made leverage strategy. You can achieve this by borrowing personally and buying additional shares in ABC Corp. Such that your overall position in the levered firm mirrors the original unlevered firm.
5. Market Value Balance Sheet (Before and After Restructure):
Before Restructure (All Equity):
Total Assets = ₹1,000,000
Total Equity = ₹1,000,000
Number of Shares Outstanding = 10,000
Stock Price = ₹1,250,000 (as calculated in question 1)
After Restructure (With Debt and Share Repurchase):
Total Assets = ₹1,350,000 (₹1,000,000 original assets + ₹350,000 in debt)
Total Equity = ₹1,000,000 (unchanged)
Number of Shares Outstanding = 9,720 (as calculated in question 3)
Stock Price = ₹1,250,000 (as calculated in question 3)
6. Market Value Balance Sheet (With Taxes):
With a tax rate of 25%, the market value balance sheet upon announcing the new debt is:
7. New Stock Price (With Taxes):
The new stock price with taxes can be calculated as:
New Stock Price = (EBIT – Interest Expense) / Cost of Equity New Stock Price = (₹100,000 – 0.25 * ₹350,000) / 0.08 New Stock Price = ₹793,750
8. Shares Repurchased (With Taxes):
The number of shares to be repurchased with taxes remains the same at 280 shares (as calculated in question 2).
9. Market Value Balance Sheet (After Repurchase with Taxes):
Total Assets = ₹1,350,000 (unchanged)
Total Equity = ₹1,000,000 (unchanged)
Total Debt = ₹350,000
Number of Shares Outstanding = 9,440 (9,720 – 280 shares repurchased)
Stock Price = To be recalculated
10. New Share Price (After Repurchase with Taxes):
New Stock Price = (EBIT – Interest Expense) / Cost of Equity New Stock Price = (₹100,000 – 0.25 * ₹350,000) / 0.08 New Stock Price = ₹787,500
11. Overall Learning:
This exercise demonstrates several important concepts in finance:
Modigliani-Miller Propositions: In a world with perfect markets and no taxes, capital structure decisions do not affect the firm’s value.
Share Repurchases: By using debt to repurchase shares, a firm can change its capital structure without affecting its overall value.
Home-made Leverage: Investors can replicate the effects of leverage by borrowing personally and adjusting their stock holdings.
Tax Effects: The introduction of taxes can influence capital structure decisions and the firm’s stock price.
Understanding these concepts is crucial for making informed financial decisions and optimizing a firm’s capital structure in the real world, where market imperfections and taxes exist.
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