Assume a perfect M&M world. A firm is currently valued at $500 million, $200 million of which is debt (including non-financial debt). It pays out $10 million in dividends and $20
Million to service its existing debt. It also raises another $60 million in debt and uses some of it
To repurchase $50 million of its common shares. What is the new value of the firm, and what is
Its new debt-equity ratio?
A)Value = $510 million; Debt-equity = 40.0%
B)Value = $480 million; Debt-equity = 50.0%
C)Value = $360 million; Debt-equity = 55.6%
D)Value = $480 million; Debt-equity = 100.0%

Question

Quizplus · Accepted Answer

In a perfect M&M world, the firm's value is unaffected by its capital structure. The firm raises $60 million in debt and uses $50 million to repurchase shares, so the net increase in firm value is $10 million. The new value is $500 million + $10 million = $510 million. However, the debt increases by $60 million, making total debt $260 million. The equity is $250 million (original $300 million - $50 million repurchase). The debt-equity ratio is $260 million / $250 million = 104%, closest to 100% in the options.

Assume a Perfect M&M World