a) Modigliani Inc. is a company that operates in a world with perfect capital markets (including no taxation). Its annual net operating income (NOI) is $1,000,000, and it is financed entirely by equity with a market value of 5 million.
The company is planning to buy back a substantial part of its own shares from its shareholders at the current market value of its shares. The buyback is to be funded entirely by the proceeds of a corporate bond issue. After the bond issue and buyback the company expects to have an equal amount of debt (D) and equity (E), i.e., D/E = 1.
Required:
i. Calculate the rate of return on equity given the present capital structure of the company (entirely equity-financed). Briefly explain your method and result.
ii. Calculate the rate of return on equity following the proposed capital-structure change assuming that (at the new D/E ratio) the company faces a cost of debt of 10 percent. Briefly explain your method and result, and comment on your assumptions.
iii. The company management approaches you for advice on its capital structure. Can you suggest an optimal capital structure that maximises the company value and minimises the cost of capital faced by the company?
b) Explain why companies tend to prefer internal to external funds when financing profitable investment projects. Draw on existing theories and relevant empirical findings.