Example on modigliani and miller approach, Financial Management

Assignment Help:

Q. Example On modigliani and miller approach?

The subsequent is the data regarding two companies X and Y belonging to the same risk class:

Company X                             Company Y

Number of Ordinary Shares                            90,000                                     1, 50,000

Market price per share                                     1.20                                         1.00

6% Debentures                                                60,000                                     ----

EBIT                                                               18,000                                     18,000

All profits subsequent to debentures interest are distributed as dividends.

Describe how under Modigliani and Miller approach an investor holding 10% shares in company X will be better off in switching his holding to Company Y.

Solution:-

(a) Investor's current position in company X with 10% equity holdings:

Investments (9000 shares X Rs. 1.20)                                    Rs. 10,800

Dividend Income 10% of (18000-6%of 60,000)                    1,440

(b) Investor sells his holdings in X for Rs. 10,800

He creates a personal leverage by borrowing Rs. 6,000. therefore,

The total amount available with him is Rs. 16,800

(c) He purchases 10% equity holding of Y for Rs. 15,000

(15,000 shares X re 1) for which he pays as follows:

From Borrowed funds                                                                                    6,000

From Own funds (15,000-6,000)                                                        9,000

(d) His dividend income is 10% of 18,000                                                     1,800

Less: Interest on personal borrowings 6% on Rs. 6000                                  360

Net Income                                                                                                     1,440

Therefore he gets the same income of Rs 1,440 from switching over to Y. However in the process he reduces his investment outlay by Rs. 1800(10,800-9,000).

Thus he is better off by investing in company Y.

(2) The Modigliani and Miller Approach-When corporate taxes are supposed to exist:-

Modigliani-Miller agrees that the value of the firm will raise and cost capital will decline with the use of debt if corporate taxes are considered. Because interest on debt is tax-deductible the effective cost of borrowing will be fewer than the rate of interest. Therefore the value of the levered firm would exceed that of the unlevered firm by an amount equal to the levered firm's debts multiplied by the tax rate. Value of the levered firm is able to be calculated on the basis of the following equation:

VL = Vu + Dt

VL = Value of Levered Firm                                      Vu = Value of Unlevered Firm

D = Amount of Debt                                                  t = Tax Rate

Equation entails that the value of the levered firm equals the value of an unlevered firm plus tax saving resulting from the use of debt.


Related Discussions:- Example on modigliani and miller approach

Define when u.s. dollar weakens in foreign exchange market, What does it me...

What does it mean when the U.S. dollar weakens in the foreign exchange market? While the U.S. dollar weakens in the foreign exchange market one U.S. dollar buys smaller amount un

Calculate the maximum price of machine, Silvana Zhang of Sajjad Jafri & Geo...

Silvana Zhang of Sajjad Jafri & Geopeng Li Limited is considering purchasing a new widget making machine. She would like to know the maximum price she should pay for the new machin

Security offered - influence the rate of interest, Q. Security offered -  ...

Q. Security offered -  influence the rate of interest ? The rate of interest charged on the loan will be lesser if the debt is secured against an asset or assets of the company

What is gatt, What is GATT, and what is its goal? GATT is the General A...

What is GATT, and what is its goal? GATT is the General Agreement on Tariffs and Trade it is a agreement that seeks to decrease trade barriers among participant nations.

Explain the relationship between growth and inequality, While poverty reduc...

While poverty reduction has become the main goal of development efforts, there is an on-going and sometimes heated debate about the elements that would be at the center of any sens

Regarding the assigment below, a-ii, should i calculate the co-variance of ...

a-ii, should i calculate the co-variance of the 30 securities?

Margin trading, Margin Trading: Suppose an investor wants to buy 100 Re...

Margin Trading: Suppose an investor wants to buy 100 Reliance Energy shares, whose market price is Rs.500. This transaction requires Rs.50,000 but the investor has only Rs.30,0

This case has been framed in order to test the skill, Ask ques1. How would ...

Ask ques1. How would you judge the potential profit of Bajaj Electronics on the first year of sales to Booth Plastics and give your views to increase the profit? 2. Suggestion rega

What are the options available for growth, What are the options available f...

What are the options available for growth Joint venture   A joint venture is when a separate company is formed, in which every member holds an equity st

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd