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IBS, Kohat University of Science and Technology.

Kohat Campus
Student Name: Roll No:
Program: Examination: Mid Term-1
Semester: Total Marks:30
Time Allowed: 24 Hours Date:
Course: Instructor Email: tanveerahmad@kust.edu.pk

INSTRUCTIONS:
1. After solving paper student is required to follow three steps, 1: clearly scan it, 2: then convert it into PDF,
3: upload on KCMS.
2. In case there is technical issue while uploading your paper over KCMS, then alternatively, student can
email his answer sheet (PDF-file) on instructor’s email address well before deadline time and clearly
mention your registration number in the subject of email.
3. Student is required to solve in his/her own writing, language and pattern. Any answer sheet found 100%
carbon copy of any other student, both will get zero marks.

Question 1: (15 Marks)

If you are working in a firm and you are assigned a task to estimate Free Cash Flow for a new project that
the company is going to start. How will you estimate these cashflows, explain the steps with the help of
numerical example?

Question 3: (15 Marks)

Explain MM theory without taxes Preposition I and II with the help of numerical example (The numerical
example should not be from lecture or book; it should be your own example).

………. Good Luck……….

Modigliani and Miller theories of capital structure (also called MM or M&M theories) say that (a) when
there are no taxes, (i) a company’s value is not affected by its capital structure and (ii) its cost of equity
increases linearly as a function of its debt to equity ratio but when (b) there are taxes, (i) the value of a
levered company is always higher than an unlevered company and (ii) cost of equity increases as a
function of debt to equity ratio and tax rate.

Modigliani and Miller’s (M&M) theories about capital structure offer a good starting point in a
company’s quest for optimal capital structure. This is even though they require certain unrealistic
assumptions such as: (a) existence of a totally efficient market with no transaction costs, (b) no financial
distress and agency costs, (b) ability to borrow and lend at the risk-free rate, etc.

M&M theories offer two propositions in two environments: (a) without tax and (b) with tax.
 1. M&M Theory: No-Tax Environment
Let’s first discuss the implications of M&M approach in a no-tax environment.

1. Proposition 1
The first proposition states that the value of a company is independent of its capital structure. It implies
that the value of an all-equity firm is equal to an all-debt firm. Using the theory’s assumptions,
Modigliani & Miller demonstrate that an arbitrage opportunity forces the values to converge.

2. Proposition 2
The second proposition states the company’s weighted average cost of capital is a function of the
company’s business risk and will remain constant regardless of the capital structure. It implies that
component cost of capital (i.e. cost of debt and cost of equity) will adjust with any change in debt to
equity ratio resulting in a constant weighted-average cost of capital.

This can be expressed as follows:

D E
WACC = kd × + ke ×
V V
Where WACC is the weighted-average cost of capital, kd is the cost of debt, ke is the cost of equity, D is
the absolute value of debt, E is the absolute value of equity and V is the value of total assets of the
company which is the sum of equity E and debt D.

After some mathematical manipulation we arrive at the following equation of cost of equity (ke):

D
ke = WACC + (WACC − kd) ×
E
The above equation means that with an increase in debt-to-equity ratio (D/E), cost of equity will increase
resulting in a constant weighted-average cost of capital (WACC) at any capital structure.

2. M&M Theory: Positive Tax Environment

M&M Theory 1’s assumption that there are no taxes is unrealistic. Taxes exist, and interest expense is tax
deductible i.e. the ultimate tax burden of a company with debt in its capital structure is lower than a
company with zero or lower debt. This brings us to M&M Theory 2 which relaxes the zero-tax
assumption.

1. Proposition 1
In a tax environment, the value of a levered company is higher than the value of an unlevered company
by an amount equal to the product of absolute amount of debt and tax rate.

This can be expressed mathematically as follows:

VL = VUL + t × D

Where VL is the value of levered company i.e. company with some debt in its capital structure, VUL is the
value of an un-levered company i.e. with no or lower debt, t is the tax rate and D is the absolute amount
of debt.

2. Proposition 2
Since interest expense is tax-deductible, our equation for the weighted average cost of capital modifies
as follows:
 E D
WACC = ke × + kd × (1 - t) ×
V V
All other variables are the same as in Proposition 2 of Theory 1 except for the factor of (1 − t) which
represents the tax shield i.e. the decrease in effective cost of debt due to existence of tax benefit of debt.

After some mathematical adjustment, we get the following function for cost of equity in a positive-tax
environment:

D
ke = WACC + (WACC − kd) × (1 − t) ×
E
The above equation is the same as in Proposition 2 of Theory 1 except for the factor of (1 − t). The
consequence of debt shield is that cost of equity increases with an increase in D/E but the increase in less
pronounced than in a no-tax environment.

The implication of M&M theory with tax is that the capital structure is no longer irrelevant. The value of a
company with debt is higher than the value of a company with no or lower debt.

3. Example
A company is considering a business in which the expected weighted average cost of capital is 10%
keeping in view the associated business risk. It has option to incorporate in Country A which has no taxes
or in Country B which as 20% corporate taxes.

If the company’s cost of debt is 6% in both countries, find out its cost of equity in both countries at the
following debt-to-equity ratio levels: (a) zero, (b) 1, and (c) 2.

Country A

Country A has no taxes, so we can use the cost of equity function as in Proposition 2 of the Theory 1:

ke @ D/E of 0 = 10% + (10% − 6%) × 0 = 10%

ke @ D/E of 1 = 10% + (10% − 6%) × 1 = 14%

ke @ D/E of 2 = 10% + (10% − 6%) × 2 = 18%

We can demonstrate that the weighted average cost of capital at all level of debt-to-equity ratio is the
same i.e. 10%. Let’s see what happens at D/E of 1 or D/V of 50%:

WACC = 50% × 6% + 50% × 14% = 10%

Country B

Existence of taxes creates a preference for debt resulting in a lower increase in equity with addition of
debt as demonstrated below:

ke @ D/E of 0 = 10% + (10% − 6%) × (1 − 20%) × 0 = 10%

ke @ D/E of 1 = 10% + (10% − 6%) × (1 − 20%) × 0 = 13.2%

ke @ D/E of 2 = 10% + (10% − 6%) × (1 − 20%) × 2 = 16.2%

The consequence of this less pronounced increase in cost of equity is that the weighted average cost of
capital decrease with increase in debt-to-equity ratio. Theoretically, the value is maximized for an all-debt
company. However, the existence of some other factors such as probability of bankruptcy, etc. causes the
cost of debt to increase such that the value of a company is maximized at some intermediate point (i.e.
between an all-debt and an all-equity capital structure).

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