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:

V_L = V_u + D_t

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.