MGT201 Financial Management GDB No. 3 Solution Fall Semester 2013

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MGT201 Financial Management GDB No. 3 Solution Fall Semester 2013


Total Marks 2
Starting Date Monday, January 28, 2013
Closing Date Wednesday, January 30, 2013
Status Open
Question/Description
Capital Structure
Learning objective
The purpose of this GDB is to learn the implications of capital restructuring under Modigliani & Miller (M&M) proposition.

Learning Outcomes
After attempting the GDB, students will be able to analyze the impact of restructuring on weighted average cost of capital under different circumstances.

Case
Suppose you are a financial analyst of ABC Company which was 100% equity financed with net worth of Rs. 10 million and Weighted Average Cost of Capital of 22%.
Management of the company has decided to change its capital structure by adding Rs. 4 million in debt at 14% cost of debt. Net income and cost of equity were Rs. 2,040,000 and 16.4% respectively after this restructuring. Moreover, Tax rate is 30%.

Required:

Keeping in view the Modigliani & Miller (M&M) theorem, you are required to calculate:

i. WACC of levered firm by ignoring tax.

ii. WACC of levered firm by considering tax.

On the basis of above calculation you are required to prove that M&M proposition are applied or not. Justify your answer with logical reasoning.