Consider two firms, U and L, that have identical assets that generate identical cash flows:

U is an all-equity firm, with 2,000,000 shares outstanding that trades for a price of $26 per share.
L has 1,000,000 shares outstanding and $12,000,000 dollars in debt at an interest rate of 6.00%.

They operate in a country with no tax. According to MM Proposition 1, the value of one share of L is closest to:

Question

Consider two firms, U and L, that have identical assets that generate identical cash flows:

U is an all-equity firm, with 2,000,000 shares outstanding that trades for a price of $26 per share.
L has 1,000,000 shares outstanding and $12,000,000 dollars in debt at an interest rate of 6.00%.

They operate in a country with no tax. According to MM Proposition 1, the value of one share of L is closest to:

BlackTom AI · Accepted Answer

We start by restating the scenario to ensure clarity: two firms, U and L, have identical assets generating identical cash flows, with U being all-equity and L having debt. U has 2,000,000 shares at $26 each, while L has 1,000,000 shares and $12,000,000 in debt at 6% interest. There is no tax.

First, compute the total value of the assets (the firm value) under MM Proposition I with no taxes: since asset cash flows are identical and capital structure changes do not create or destroy value in a no-tax world, V_U = V_L = value of the assets. The value of U’s equity is simply the number of shares times price: 2,000,000 × $26 = $52,000,000. Therefore, V_U = $52,000,000, which must equal the total value of L’s assets as well: V_L = $52,000,000.

Next, determine L’s equity value given its debt: V_L = Debt + Equity. We know V_L = $52,000,000 and Debt = $12,000,000, so Equity = V_L − Debt = $52,000,000 − $12,000,000 = $40,000,000.

Now find the price per share for L by dividing equity value by the number of shares outstanding: $40,000,000 ÷ 1,000,000 shares = $40.00 per share.

Why this result makes sense conceptually: under MM Prop I with no taxes, debt financing does not change the total value of the firm; it simply reallocates value between debt holders and equity holders. By introducing debt of $12 million, the equity value must drop from $52 million (if all-equity) to $40 million, keeping the total at $52 million. The per-share price reflects this allocation across the 1,000,000 shares outstanding.

Potential misconceptions to address:
- If someone thinks leverage creates extra value in a no-tax world, that is incorrect; leverage does not increase the firm’s total value here, only the capital structure distribution.
- If one misapplies the debt amount or miscomputes shares outstanding, the share price would be off. Here the key steps are: establish V = $52M, subtract debt $12M to get equity $40M, then divide by 1M shares to get $40 per share.

In summary, given the no-tax MM framework and identical asset values, L’s levered equity is worth $40,000,000 and with 1,000,000 shares outstanding, the price per share is $40.00.

Similar Questions

Which of the following statements best reflects the key insight of the M&M Proposition (without taxes)?

In a world with perfect capital markets, a firm that issues a large amount debt to finance a share repurchase will ultimately boost its EPS and reduce its post-transaction market capitalization, but will not affect its stock price.

In a world with corporate taxes (only capital markets imperfection), a levered firm will issue equity to repay some of its debt. Indicate which of the following statements is correct:

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