FIN622 Corporate Finance GDB Solution Fall 2012

JR is a medium scale company working in leather industry. From the analysis of last year’s financial performance that was not satisfactory in term of operational efficiency and profits, management of JR Company has decided to go for capital restructuring. Major objectives of capital restructuring are to improve profits and modification in ownership framework. Currently company is operating at 20% of debt and 80% of equity with 15% weighted average cost of capital (ignoring tax).

MR. A, the financial manager of the company has proposed 40:60 debt to equity ratio with 7% cost of debt. Mr. A supports his proposed capital structure on the basis of M & M propositions.
 


 
There are different theories of capital structure; one of those is Modigliani and Miller theorem based on some assumptions known as its propositions. M&M Proposition-I states “the vale of firm is independent of its capital structure if we ignore tax” and M&M Proposition-II is related to firm’s cost of equity which says that “a firm’s cost of equity is a positive linear function of its capital structure” (ignoring tax).

Required:
Being a student of finance you have to analyze the implication of proposition I and II of M&M model (Ignoring taxes) in JR Company on the basis of following calculations.
1. Cost of equity before and after capital restructuring.
2. Which M & M proposition hold true for proposed capital structure? Give logical reasoning to support your answer.

Solution:


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