Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, how much of the special dividend do you receive, and how much do you receive in regular dividends per year after the restructuring according to M&M Proposition 1?
A) $15 and $60
B) $60 and $15
C) $10.80 and $22.50
D) $22.50 and $10.80

Question

Quizplus · Accepted Answer

M&M Proposition I states that the value of a leveraged firm is the same as the value of an unleveraged firm, assuming no taxes and no bankruptcy costs. The total value of the firm is the present value of its cash flows. The current value of the firm (V) is calculated as the annual cash flow ($150) divided by the discount rate (10%), which equals $1500. When the firm restructures to 60% equity, the value of the firm remains the same ($1500), but the equity portion changes. The new equity value is 60% of $1500, which equals $900. Since you own 10% of the stock, your share of the equity before restructuring is 10% of $1125 (75% of $1500), which equals $112.50. After restructuring, your share of the equity is 10% of $900, which equals $90. The difference, $22.50, is the special dividend you receive due to the restructuring. After the restructuring, the firm still produces $150 in annual cash flows. Your share of these cash flows, given your 10% ownership, is 10% of $150, which equals $15. However, because the firm's capital structure has changed, the cost of equity may change, affecting the regular dividends you receive. Assuming the cost of equity remains constant for simplicity, your regular dividend remains 10% of the annual cash flow, which is $15. Therefore, you receive a special dividend of $22.50 due to the restructuring and continue to receive $15 in regular dividends per year.