Modern capital structure theory began in 1958, when Professors, Franco Modigliani and Merton Miller (hereafter MM) published an article: “The Cost of Capital, Corporation Finance and the Theory of Investment”, which has been called the most influential finance article ever written. M&M’s study was based on some strong assumptions known as its propositions. M&M Proposition I says that “the vale of firm is independent of its capital structure” 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”.
Being a finance student, you have to apply and analyze “M&M Propositions” in Model Company Limited (MCL) which has weighted average cost of capital (ignoring taxes) of 14 percent and it can borrow funds at 6 percent. Its existing capital structure is Rs. 1 Million with debt-equity ratio at 40:60. MCL’s management is desirous to restructure this ratio as 70:30. The country’s central financial authorities have no objection on this desired capital structure.
1. Compute the cost of equity of MCL before and after restructuring.
2. Compute weighted average cost of capital (WACC) before & after restructuring.
3. Did you find “M&M propositions” true in above cases (question 01 and 02). Why?
Solution idea from text book here
Check the link for formula to calculate MCL and WACC. Comment below and discuss.
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