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, what transaction do you need to take in order to undo the restructuring according to M&M Proposition 1?
A) Sell $22.50 of stock
B) Sell $10.80 worth of stock
C) Buy $22.50 worth of debt
D) Buy $10.80 worth of debt

Question

Quizplus · Accepted Answer

According to M&M Proposition 1, to undo the restructuring, you should buy debt equivalent to the amount of equity sold. The firm is reducing equity from 75% to 60%, a 15% reduction. Your 10% ownership means you need to buy 10% of the debt issued to maintain your position. The firm value is $150/0.10 = $1500. 15% of $1500 is $225, and 10% of that is $22.50.