Tutor.

com Finance Resources Kirk Vandezande

MM Recapitalization Example
Summer 2021

Firm ABC is financed with equity (market value E = $400 million) and perpetual debt
(B = $1,000 million). The firm has decided that the current level of leverage is not
optimal and wants to reach a debt-equity ratio of 0.60. To achieve this goal, ABC
plans to issue equity and retire some existing debt. Assume that the firm operates in
a Modigliani and Miller world (i.e., markets are efficient, no transaction costs, no
financial distress costs, etc.) except for a corporate tax rate of 30%.

1. Determine the amount of debt the Firm ABC needs to repay to reach the target
debt-equity ratio, and the value of debt and equity after the restructuring.

By MM Prop I, , which implies . Let the optimal

level of debt be . By substituting, we can write E* and B* as functions of .

With values from the problem text,

To refinance, ABC issues equity to reduce debt by $535.2113m, from $1000m to

$464.7887m.
Summer 2021 MM Recap, p. 2

2. Assume that there are 20 million shares outstanding before the restructuring. How
many shares must ABC issue to repay the debt and reach its new target
debt/equity ratio?

Before refinancing, the share price was $20/sh ($400m / 20m shares).

, B = 1,000m, E = 400m and

V L = 1400m.

Upon refinancing, existing shareholders give up the value of the lost tax shields:
$(1,400  1,239.437)m = 160.563380m. Dividing by 20m shares, the loss in the
value of tax shields is $8.028169 / sh. The value of each share is now
$11.971831/share, $ (20 – 8.028169)/sh. At the new share price, the firm must
sell 44.706718m shares to raise $535.2113m.

Original Cap Announce

Component Structure Restructuring Sell Shares, Retire Debt
Unlevered Equity $ 1,100 m $ 1,100 m $ 1,100 m
PV(Int TS) 300 m 139,436,620 139,436,620
Total Value 1,400 m $ 1,239,436,620 $ 1,239,436,620
Debt $ 1,000 m $ 1,000 m 464,788,732
Shares $20/sh  20 m $11.9718/sh 20 m $11.9718  64,706,718 sh
Equity $ 400 m 239.436.620 774,647,887
D/E Ratio 1000/400 = 2.5 1000/239.4 = 4.176 464.79 / 774.65 = 0.60

3. Solve part (1) assuming ABC’s debt is not perpetual but 10-yr bonds with a 10%
annual coupon rate and a nominal value of $1,000 million. Debt market value B is
still $1,000 million.

With perpetual debt, the tax shield is worth . For finite-lived debt worth B
with coupon rate CR, yield to maturity y, time to maturity T, and face value D,
the present value of tax shields (PVTS) looks like this (use the bond-pricing
equation):
Summer 2021 MM Recap, p. 3

If the bond sells at par, and . Then .

Because coupon payments stop at T years instead of continuing perpetually, so

PVTS shrinks.

To find the debt to repay so the leverage ratio is  = 60%, let k = .

and

For T=10 and y = 10%, k = 0.6144567 and ktc = 0.184337013. Then,

To refinance, firm ABC must reduce debt from $1000m to $489,726,653, paying
back $510,273,347 by issuing equity.
Summer 2021 MM Recap, p. 4

4. Assume now that ABC operates in a tax-free regime. Market value of debt and
equity is still $1,000 million and $400 million, respectively. Determine the amount
of debt ABC needs to repay to reach the target debt-equity ratio of 0.6, and the
value of debt and equity after the restructuring. Consider both the case in which
debt is perpetual and the case in which debt consists of 10-year bonds.

First, for tC = 0 and perpetual debt,

, ,

To refinance, ABC reduces debt from $1000m to $525m, paying back $475m by
issuing equity.

With 10-year bonds and tC = 0, then ktC = 0, too. We have precisely the same
results. ABC reduces debt from $1000m to $475m, paying back $525m by issuing
equity.