Problems
11.1 Why is debt finance usually cheaper than equity finance in the same business?
11.2 According to MM, what happens to the cost of equity as gearing increases (ignoring
taxation)?
11.3 According to MM, and taking account of taxation, what happens to the cost of equity
as gearing increases?
11.4 One of the MM assumptions is ‘no bankruptcy costs’. What costs does this phrase
represent?
11.5 How do we know that the managements of most businesses believe in the benefits of
gearing?
11.6 What is the difference between the value of an ungeared and a geared business
according to MM (taking account of taxation)?Review questions
Suggested answers to
Review questions
in Appendix 3.
(Problems 11.1 and 11.2 are basic-level problems, whereas problems 11.3 to 11.7 are
more advanced and may contain some practical complications.)11.1*Shiraz plc is financed by 10 million shares, whose current market value is £2.40 a
share, and 10 per cent loan notes with a nominal and market value of £14 million. The
return on the ordinary shares is 20 per cent.
Making Modigliani and Miller’s original assumptions (including that of no taxes), what
would be the equity rate of return and the share price of an identical business that was
all-equity financed?11.2 Merlot plc is financed by 10 million shares, whose current market value is £2.40 a
share, and 10 per cent loan notes with a nominal and market value of £14 million. The
business plans to issue additional shares to raise £14 million and to use the cash gen-
erated to pay off the loan notes. The corporation tax rate is 30 per cent.
(a) Making Modigliani and Miller’s assumptions (in a world with taxes), how would the
restructuring described affect the value of the business?
(b) If the shareholders gain, who will lose, or if the shareholders lose, who will gain?11.3*Particulate plc is an all-equity-financed business with a market value of £35 million
and a cost of capital (after tax) of 20 per cent p.a.
The business intends to purchase and cancel £8 million of equity finance using the
cash raised from issuing 10 per cent irredeemable loan notes. The rate of corporation
tax is 30 per cent.
Assuming that the assumptions of Modigliani and Miller (in a world with taxes) are cor-
rect, how will the capital restructuring affect:
(a) the market value of Particulate plc;
(b) its cost of equity; and
(c) its weighted average cost of capital?Problems
Sample answers to
problems marked with
an asterisk appear in
Appendix 4.
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