Question 4

Marcus plcs ordinary equity is listed on the UKs stock market. The firms directors who also are majority shareholders of the firm are assessing some new investment projects. If they proceed with these projects, 48 million of additional capital needs to be raised. The required rate of return for these new projects is 20% per year pre-tax.

The 2021 financial information of the firm is as follows :

Earnings before interest & tax (EBIT) for current operations = 89.50 million

No. of shares to be sold = 60 million

Par value of share = 1

Currently, the firm is only financed by equity. It possesses the flexibility of raising new capital by debt or equity. If equity is used, the firm will sell new equity at a 20% discount to the current market price of the stock. If debt is used, the firm will sell bonds at par value with no collaterals needed at an interest of 10%. If equity is used, the P/E ratio of the firm has a high likelihood to increase from its current level of 10 to 10.5. However, if debt is used, its P/E ratio is likely to be reduced to 7.5. Corporate tax rate is 35%. Ignore flotation costs.

Required:

1. Find out the expected price of equity, total equity value and firm value within the 2 choices of financing. Critically explain which financing choice is better.

(6 marks)

2. One day, John, who is one of the directors of Marcus plc told his colleague, Peter that MM Propositions are free from problems which affect financial models which are generated by Marcus plc. Do you agree or disagree with Johns viewpoint ? Critically justify your stance with proper explanations. (10 marks)

3. Critically discuss the main assumptions of MM Propositions Without Tax and explain why in perfect capital market conditions, firm value will not be influenced by its capital financing choices. (9 marks)

[Total : 25 Marks]