- 6 Marks
FM – L2 – Q37 – Capital structure
Question
A company has 4,000,000 equity shares in issue. The shares have a current market value of GH¢10 each. The company is considering whether to issue GH¢15,000,000 of debt finance and use the cash to buy back and cancel some equity shares. The tax rate is 30%.
According to Modigliani and Miller, if the company decided to issue the debt capital and repurchase shares, what would be:
(a) the total value of the geared company, and (3 marks)
(b) the value of equity in the company? (3 marks)
Answer
Value of geared company = Value of company ungeared + (Value of debt × tax rate)
V_g = V_u + Dt
V_g = (4,000,000 × GH¢10) + (GH¢15,000,000 × 30%)
= GH¢44,500,000
Total value of geared company (equity + debt) = GH¢44,500,000
Value of debt = GH¢15,000,000
Therefore value of equity in geared company = GH¢44,500,000 – GH¢15,000,000 = GH¢29,500,000
The total value of the equity in the geared company is lower than when the company was ungeared, but there are fewer shares left in issue and the value per share will be higher.
- Topic: Capital structure
- Uploader: Samuel Duah