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Firms Alpha Ltd., Beta Ltd., and Delta Ltd. are identical firms with same business operations and risk. They all generate a 20% return on capital.

Firms Alpha Ltd., Beta Ltd., and Delta Ltd. are identical firms with same business operations and risk. They all generate a 20% return on capital. The only difference between them is their capital structure. Alpha Ltd. is unlevered firm funded by 50,000 shares of 10 each. Beta Ltd. is funded by 30,000 shares of face value 10 and a debenture of 2,00,000. Delta Ltd. has financed itself by 25,000 shares of 10 each and 2,50,000 by debt financing.

These companies can raise debt at interest rate of 6%. Equity investors expect a return of 9% from companies like these.

For the traditional approach you can use the table below which estimates the change in investor's risk perception with respect to debt ratio changes

Debt ratio

ke

kd

0

9%

0%

10%

9.05%

6%

20%

9.09%

6.02%

30%

9.20%

6.35%

40%

9.75%

6.90%

50%

11%

8.50%

60%

12.50%

10%

70%

14%

11%

80%

20%

15%

90%

30%

20%

100%

0%

30%

  1. Assuming no taxes, what is the value of each firm as per each of the Net Income theory, the Traditional theory, and the Modigliani-Miller theory. [9]
  2. Does the value of each firm differ across these three theories? Why? [6]

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