You are an entrepreneur starting a biotechnology firm. If your research is succe

Question

You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $30 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $2.0 million. Investors are willing to provide you with $2.0 million in initial capital in exchange for 50%

of the unlevered equity in the firm.

a. What is the total market value of the firm without leverage?

b. Suppose you borrow $1.0 million. According to MM, what fraction of the firm's equity will you need to sell to raise the additional $1.0

million you need?

c. What is the value of your share of the firm's equity in cases

(a)

and

(b)?

Explanation / Answer

a)

Total value of equity: 2 * $2m = $4m

b)

MM says total value of firm is still $4 million.

$1 million of debt impliestotal value of equity is $3 million.

Therefore, 33% of equity must besold to raise $1 million

c)

In (a), 50% × $4m = $2m.

In (b), 2/3 × $3m = $2m.

Thus, in a perfect market the choice of capital structure does not affect the value to the entrepreneur.

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