MGT201 GDB 2 Spring 2012 solution

Modern capital structure theory began in 1958, when Professors, Franco Modigliani and Merton Miller (hereafter MM) published an article: “The Cost of Capital, Corporation Finance and the Theory of Investment”, which has been called the most influential finance article ever written. M&M’s study was based on some strong assumptions known as its propositions. M&M Proposition I says that “the vale of firm is independent of its capital structure” and M&M Proposition II is related to firm’s cost of equity which says that “a firm’s cost of equity is a positive linear function of its capital structure”.

Being a finance student, you have to apply and analyze “M&M Propositions” in Model Company Limited (MCL) which has weighted average cost of capital (ignoring taxes) of 14 percent and it can borrow funds at 6 percent. Its existing capital structure is Rs. 1 Million with debt-equity ratio at 40:60. MCL’s management is desirous to restructure this ratio as 70:30. The country’s central financial authorities have no objection on this desired capital structure.
Required:
1.      Compute the cost of equity of MCL before and after restructuring.
2.      Compute weighted average cost of capital (WACC) before & after restructuring.
3.      Did you find “M&M propositions” true in above cases (question 01 and 02). Why?
Solution idea from text book here