Three ABC Ltd generates operating income of sh.4 million each year and pays corporation tax rate at the rate of 30%.The minimum required rate of return on equity in the absence of debt borrowing is 10%.The pre-tax cost of debt is 8%. Required: Using the Modigliani and miller's proposition, answer the following questions: i) In the absence of personal taxes, determine the current market value and weighted average cost of capital of a levered firm (4 Marks) ii) With reference to (i) above, assume that personal as well as corporation taxes now exist. The marginal personal tax rate on stock income is 5% and the marginal personal tax rate on debt income is 15%. Determine the current market value of the company and Weighted average cost of capital (WACC) of levered firm (4 Marks) iii) Briefly comment on the results in (i) and (ii) above (2 Marks) b) Ali ltd and Bali Ltd are firms operating in the same industry and are considered to be in the same risk class. Each firm has a gross operating profit of sh.250, 000,000 p.a. The capital structures are as follows: Ali Ltd Bali Ltd (Millions) (Millions) Equity (market value) 1,750 1,500 8% Debt (trading at par) - 1,000 1750 2,500 The two companies adopt a 100% dividend payout policy. Tax rate is 30%. Required: Using Modigliani and miller's with corporation taxes model determine i)The equilibrium market value of both firms (3 Marks) ii)Weighted average cost of capital for both firms (5 Marks) iii) What is your observation and why? (2 Marks) (Total: 20 Marks)

Answer rating: 100% (QA)

a Modigliani and Millers Proposition i In the absence of personal taxes Current Market Value of the Levered Firm VL Using the Modigliani and Millers Proposition the market value of a levered firm can ... View the full answer