Assume there are two companies operating in the same industry. The two companies are almost identical. The only difference is their capital structure. Company UU has only equity while company LL has 30% of debt and 70% of equity.
Further assume that both companies have the same expected net operating income of $1,000. We make a further assumption that this stream of income will last forever. The required rate of return for both companies is 5%.
a) According to the Modigliani-Miller model, what is the value of company UU and company LL? Explain.
b) Assume that the capital structure of company UU changes. The new capital structure is such that company UU has 20% of debt and 80% of equity. Does your result in a) change? Explain.
c) Under which circumstances, in your opinion, might the Modigliani-Miller model work?
d) Assume you have just been appointed financial manager of company UU. You need to decide what the optimal capital structure is.
What would you do?
Modigliani-Miller model is utilized.