Suppose that the only departure from the Modigliani-Miller assumptions is that w

Question

Suppose that the only departure from the Modigliani-Miller assumptions is that we have a corporate income tax with a rate of 20%. Superdeal Inc. is currently fully equity financed. It has 20,000 shares with a price of $300 each. Superdeal currently has an equity beta of 1.2. The expected return on the market portfolio is 10%. Superdeal decides to borrow $2,000,000 at 5% to buy back some of its shares. The debt is perpetual and risk-free.

What is the expected price of a Superdeal share after the change in its capital structure?

Explanation / Answer

Current Value of Superdeal Inc. = 20000 x 300 = $6,000,000

Ke(Ko) = Rf + (Rm - Rf) x Beta = 5 + (10 - 5) x 1.2 = 11% (Because in unlevered firm Ko is equal to Ke)

Value of Levered firm = Value of unlevered firm + Debt x Tax Rate
Value of Superdeal after Debt = 6,000,000 + 2,000,000 x 0.2 = $6,400,000
Value of equity = Value of Firm - value of debt = 6,400,000 - 2,000,000 = $4,400,000

Expected Value of share = Value of equity / Number of shares = 4,400,000 / 20,000 = $220 per share

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