Part A
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure.
Explain and discuss their theorem along with a critique of the advantages and disadvantages of the theorem
Part B
Beyond Ltd management believes its optimal capital structure weights are as follows:
35% Long term Debt
15% Preference Shares
50% ordinary Share Capital
The firm is in the 40% tax bracket.
The firm's Investment Opportunities Schedule
|
Project
|
IRR
|
Initial Investment
|
|
A
|
14%
|
$300,000
|
|
B
|
25%
|
$400,000
|
|
C
|
17%
|
$600,000
|
|
D
|
14%
|
$500,000
|
|
E
|
19%
|
$300,000
|
|
F
|
16%
|
$800,000
|
|
G
|
15%
|
$400,000
|
Financing cost data is as follows:
Long-term debt:
The firm can raise $550 000 of additional debt by selling 15-year, $1000 par value, 9% coupon interest rate bonds that pay annual interest. It expects to net $960 per bond after flotation costs. Any debt in excess of $550 000 will have a before-tax cost, kd, of 13%.
Preference share capital:
Preference shares, regardless of the amount sold, can be issued with a $80 par value, 14% annual dividend rate and will net $75 per share after flotation costs.
Ordinary share equity:
The firm expects dividends and earnings per share to be $0.96 and $3.20, respectively, in 2008, and to continue to grow at a constant rate of 11.5% per year. The firm's shares currently sell for $14 per share. Beyond expects to have $1.75 million of retained earnings available in the coming year. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new ordinary shares, netting $10 per share after underpricing and flotation costs.
Calculate the cost of each source of financing, as specified:
a. Long-term debt, first $550 000.
b. Long-term debt, greater than $550 000
c. Preference shares, all amounts
d. Ordinary share capital, first $1.75 million
e. Ordinary share capital, greater than $1.75 million.
f. Find the break points associated with each source of capital and use them to specify each of the ranges of total new financing over which the firm's WACC remains constant.
g. Calculate the WACC over each of the ranges of total new financing specified in f.
h. Using your findings in g along with the IOS, draw the firm's weighted marginal cost of capital (WMCC) and IOS on the same set of axes (total new financing or investment on the x-axis and WACC and IRR on the y-axis).
i. Which, if any, of the available investments would you recommend that the firm accept? Explain your answer.