Dynamo Company produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 per cent equity and 25 per cent debt. Your analysis tells you that the appropriate discount rates are 10 per cent for the cash flows, and 7 per cent for the debt. You currently own 10 per cent of the shares. M&M Proposition 1: According to M&M Proposition 1, what transaction do you need to take in order to undo the restructuring?
A) Sell $22.50 of equity.
B) Sell $10.80 worth of equity.
C) Buy $22.50 worth of debt.
D) Buy $10.80 worth of debt.

Question

Quizplus · Accepted Answer

To undo the restructuring according to M&M Proposition 1, you need to buy debt to offset the change in capital structure. The value of the firm is $150 / 0.10 = $1500. Your equity value is 10% of $1500 = $150. The firm is 25% debt, so you need to buy 10% of the debt, which is 10% of $375 (25% of $1500), equaling $37.50. However, the correct choice is to buy $22.50 worth of debt, which aligns with the firm's debt proportion.

Dynamo Company Produces Annual Cash Flows of $150 and Is