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Question 3 Miller and Modigliani on Capital Structure (a) Dorothy Ltd earns an EBIT of $18 million, on average every year and this is not expected to change. Dorothy's all-equity cost of equity is 12% after having been adjusted for all taxes. The tax rates are: Company tax rate Personal tax rate on equity distributions Personal tax rate on interest income 30% 30% 30% Dorothy Ltd has $15 million of debt on which the firm pays 6% interest before tax. Required (i) Assuming Dorothy Ltd pays all available net income out as dividends, what is the unlevered value of the firm? (2 marks) (ii) Assuming Dorothy Ltd pays all available net income out as dividends, what is the levered value of the firm? (2 marks) (iii) Assume now that Dorothy Ltd has a payout ratio of 60%. Recalculate both the unlevered value of the firm and the levered value of the firm. (4 marks) (iv ) ) Assume now that the firm still pays out 60% of net income as dividends, but that the dividends are fully covered by imputation credits. What is the value of the firm, unlevered and levered now? (4 marks) (v) Please explain, in a short paragraph, what your results illustrate about the nature of Miller and Modigliani's proposition governing the value of the firm with both company taxes and personal taxes. (2 marks) (b) Draw a diagram of the cost of debt, the cost of equity and the weighted average cost of capital (WACC) that conforms to Proposition 2 of Miller and Modigliani's model of firm value in a world with company taxes only. The diagram may be roughly sketched but should take up half a page. Then, on your same diagram, please draw in the changes that occur when Miller and Modigliani's two assumptions of a single interest rate and the non-existence of bankruptcy are dropped. Please label your axes, all your lines and any other items of interest. (4 marks) TOTAL: 18 MARKS Page 5 of 15 Question 3 Miller and Modigliani on Capital Structure (a) Dorothy Ltd earns an EBIT of $18 million, on average every year and this is not expected to change. Dorothy's all-equity cost of equity is 12% after having been adjusted for all taxes. The tax rates are: Company tax rate Personal tax rate on equity distributions Personal tax rate on interest income 30% 30% 30% Dorothy Ltd has $15 million of debt on which the firm pays 6% interest before tax. Required (i) Assuming Dorothy Ltd pays all available net income out as dividends, what is the unlevered value of the firm? (2 marks) (ii) Assuming Dorothy Ltd pays all available net income out as dividends, what is the levered value of the firm? (2 marks) (iii) Assume now that Dorothy Ltd has a payout ratio of 60%. Recalculate both the unlevered value of the firm and the levered value of the firm. (4 marks) (iv ) ) Assume now that the firm still pays out 60% of net income as dividends, but that the dividends are fully covered by imputation credits. What is the value of the firm, unlevered and levered now? (4 marks) (v) Please explain, in a short paragraph, what your results illustrate about the nature of Miller and Modigliani's proposition governing the value of the firm with both company taxes and personal taxes. (2 marks) (b) Draw a diagram of the cost of debt, the cost of equity and the weighted average cost of capital (WACC) that conforms to Proposition 2 of Miller and Modigliani's model of firm value in a world with company taxes only. The diagram may be roughly sketched but should take up half a page. Then, on your same diagram, please draw in the changes that occur when Miller and Modigliani's two assumptions of a single interest rate and the non-existence of bankruptcy are dropped. Please label your axes, all your lines and any other items of interest. (4 marks) TOTAL: 18 MARKS Page 5 of 15

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