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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
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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