Question 3 OR
MM approach: how a 10% holder of P gains by switching to Q
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 3 OR · 15 marksData about two companies, P and Q, in the same equivalent risk class are below:
| Particulars | Company P | Company Q |
|---|---|---|
| Ordinary shares (number) | 1,08,000 | 1,80,000 |
| Per share market price | Rs. 1.20 | Rs. 1.00 |
| 6% Debentures | Rs. 72,000 | — |
| Profit, before interest | Rs. 21,600 | Rs. 21,600 |
All the profits after debenture interest are paid out as dividend.
Explain how, under the Modigliani and Miller Approach, an investor who holds 10% shares in Company P will be better off if he switches his holding to Company Q. 15
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Values and capitalisation rates of P and Q 4 marks 7 min
- 2 Investor's present position 2 marks 4 min
- 3 Switching steps and funds available 3 marks 5 min
- 4 Income after switching and the gain both forms 4 marks 7 min
- 5 Equilibrium through arbitrage 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 30 minutes for 15 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Values of the two companies (no taxes, as MM assume; all profit after interest paid as dividend)
| Particulars (₹) | Company P | Company Q |
|---|---|---|
| Profit before interest | 21,600 | 21,600 |
| Less: debenture interest @ 6% | 4,320 | — |
| Earnings for equity | 17,280 | 21,600 |
| Market value of equity | 1,29,600 | 1,80,000 |
| Market value of debt | 72,000 | — |
| Value of the company | 2,01,600 | 1,80,000 |
| Equity capitalisation rate (earnings ÷ equity value) | 13.33% | 12.00% |
P, the levered firm, is valued higher than Q although both are in the same risk class with the same operating profit; under MM the value of a levered firm can be neither greater nor lower than that of an unlevered one. Under MM this cannot last: investors substitute personal leverage for corporate leverage, selling the overvalued firm's shares and buying the undervalued firm's.
Present position of the investor. 10% of P's shares (10,800 shares × ₹1.20) = ₹12,960; income 10% × 17,280 = ₹1,728.
| Step | ₹ |
|---|---|
| Sell 10% of P's shares | 12,960 |
| Borrow personally 10% of P's debt at 6% | 7,200 |
| Funds available | 20,160 |
Invest all ₹20,160 in Q's shares (Q earns 12% on its equity value): income 20,160 × 12% = 2,419.20, less interest 6% × 7,200 = 432: ₹1,987.20, a gain of ₹259.20 a year over ₹1,728, with the same leverage, since his own debt replaces his share of P's.
Alternatively, buy just 10% of Q for ₹18,000: income 10% × 21,600 = 2,160 less interest 432 = ₹1,728, the same income as before, while ₹2,160 is left over to invest elsewhere: the same return at a lower outlay.
Either way he is better off. Investors will keep switching, lowering P's share price and raising Q's, until the two firms have equal total values; then arbitrage stops.
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Values and capitalisation rates of P and Q | 4 |
| 2 | Investor's present position | 2 |
| 3 | Switching steps and funds available | 3 |
| 4 | Income after switching and the gain (both forms) | 4 |
| 5 | Equilibrium through arbitrage | 2 |
| Total | 15 |
Report a problemopens an email to admin@getkunji.com with the question ID7035-Q3ORalready filled in.