Case #31 illustrates the famous M&M theory about the relationship between debt and firm value in a taxable world. Furthermore, the case illustrates the core principle of value additivity as implied in the M&M theory. Value additivity holds that the value of the whole enterprise equals the sum of the values of the debt cash flows and the equity cash flows, and also equals the value of the unlevered firm plus the present value of debt tax shields. Study the case and complete following assignments. All the calculation round up to whole dollar.

1. Please use excel spreadsheet and apply correct cell formula to fill in the table in page 425. Why does the value of assets change? Where, specifically, do those changes occur? (FYI: levered beta = Unlevered Beta * [1 + (1 - Tax Rate) * Debt / Equity])

2. Please use excel spreadsheet and apply correct cell formula to fill in the table in page 426. As the firm levers up, how does the increase in value get apportioned between the creditors and the shareholders?

3. Please use excel spreadsheet and apply correct cell formula to fill in the table in page 427. Interpret the M&M theory in your own words. Does debt policy affect firm value in a tax free world? Why or why not?

4. Please use excel spreadsheet and apply correct cell formula to fill in the table in page 428. How does increase leverage affect total value of equity, and price per share?

5. Based on the previous sets of calculation, is leverage good for shareholders? Why? In what sense should shareholders pay a premium for shares of levered companies?

6. Apply the M&M theory to complete the worksheet for the recapitalization alternative on page430. Again use excel spreadsheet and correct cell formula. Based on your calculation result, do you think the recapitalization alternative will deter the hostile tender offer at $61 a share?

PLEASE ANSWER ALL THE QUESTIONS.

31 An Introduction to Debt Policy and Value Many factors determine how much debt a firm takes on. Chief among them ought to be the effect of the debt on the value of the firm. Does borrowing create value? If so, for whom? If not, then why do so many executives concem themselves with leverage? If leverage affects value. then it should cause changes in either the discount rate of the firm (that is, its weighted-average cost of capital) or the cash flows of the firm. 1. Please fill in the following: 25% Debt/ 100% Equity 75% Equity 50% Equity Book Value of Debt Book Value of Equity $10,000 $7,500 Market Value of Debt Market Value of Equity Pretax Cost of Debt After-Tax Cost of Debt Market Value Weights of Cost of Equity Weighted Average Cost of Capital $1.485 $1485 Taxes 34%) This note was prepared by Robert usa basis for clasa discussion rather than no inustrate effective or ineffective handling of an administrative situation copyright c 1989 by the University Virginia school Foundation, Carlottesville, VA All rights reserved. Toowler copies, send an sales edandenbusinesspublishing com Noparet this publication maybe reproduced stored a vorwadsheet or tranamirend in anyform or by any mean- electronic mechanical used in a recording or otherwis-without the Permission of Darden school Randation Rev. 0612