All profits after paying debenture interest are distributed as dividends.You are required to explain how under Modigliani and Miller approach, an investor holding10% of shares in company ‘X’ will be better off in switching his holding to company ‘Y’.SolutionAs per the opinion of Modigliani and Miller, two similar firms in all respects excepttheir capital structure cannot have different market values because of arbitrage process.In case two similar firms except for their capital structure have different market values,arbitrage will take place and the investors will engage in ‘personal leverage’ as against thecorporate leverage. In the given problem, the arbitrage will work out as below.1. The investor will sell in the market 10% of shares in company ‘X’ for 75,000×10/100×1.25=Rs. 93752. He will raise a loan of Rs. 40,000×10/100=Rs. 4000To take advantage of personal leverage as against the corporate leverage the company‘Y’ does not use debt content in its capital structure. He will put 13375 shares in company‘Y’ with the total amount realized from 1 and 2 i.e., Rs. 9375 plus Rs. 4000. Thus he willhave 10.7% of shares in company ‘Y’.The investor will gain by switching his holding as below:Present income of the investor in company ‘X’ Rs.Profit before Interest of the Company 25,000Less: Interest on Debentures 5% 2,000Profit after Interest 23,000Share of the investor = 10% of Rs. 23,000 i.e., Rs. 2300Income of the investor after switching holding to companyProfit before Interest of the company Rs. 25,000Less Interest ——Profit after Interest 25,000Share of the investor : 25,000× 13,3751,25,000 = Rs. 2,675Interest paid on loan taken 4000×5/100 200Net Income of the Investor 2,475Capital Structure 61As the net income of the investor in company ‘Y’ is higher than the cost of incomefrom company ‘X’ due to switching the holding, the investor will gain in switching hisholdings to company ‘Y’.Exercise 8Paramount Products Ltd. wants to raise Rs. 100 lakh for diversification project. Currentestimates of EBIT from the new project is Rs. 22 lakh p.a.Cost of debt will be 15% for amounts up to and including Rs. 40 lakh, 16% for additionalamounts up to and including Rs. 50 lakh and 18% for additional amounts above Rs. 50 lakh.The equity shares (face value of Rs. 10) of the company have a current market value ofRs. 40. This is expected to fall to Rs. 32 if debts exceeding Rs. 50 lakh are raised. Thefollowing options are under consideration of the company.Option Debt EquityI 50% 50%II 40% 60%III 60% 40%Determine EPS for each option and state which option should the Company adopt.Tax rate is 50%.
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