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Canalot PLC

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Canalot PLC

  • This topic has 1 reply, 2 voices, and was last updated 6 years ago by John Moffat.
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    Posts
  • January 3, 2019 at 9:10 am #499761
    lachu910
    Member
    • Topics: 28
    • Replies: 38
    • ☆☆

    Canalot plc is an all-equity company with an equilibrium market value of £32.5 million
    and a cost of capital of 18% per year.
    The company proposes to repurchase £5 million of equity and to replace it with 13%
    irredeemable loan stock.
    Canalot’s earnings before interest and tax are expected to be constant for the
    foreseeable future. Corporate tax is at the rate of 35%. All profits are paid out as
    dividends.

    We are required to calculate cost of equity. In this scenario how are to find value of debt and value of equity after taking into effect the tax using modigliani & miller method

    the answer says

    total value of firm is equity- 32.5 + debt -5*.35=1.75…total=34.25

    Value of debt is 5 and value of equity is 29.5(ie 34.25-5)

    i dont understand why equity is 29.5 it says market value is 32.5

    January 3, 2019 at 9:41 am #499782
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54671
    • ☆☆☆☆☆

    The question says that they are repurchasing equity of $5M, so the value of the equity will not remain at $32.5M. It will fall because of the repurchase, but will increase because of the tax benefit of the debt.

    Therefore the new MV of the equity is 32.5M – 5M + (0.35 x 5M) = 29.25M

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