CITY Manufacturing Company, ‘CITY’, is financed entirely with 2,592,000 shares of common stock...

Question

CITY Manufacturing Company, ‘CITY’, is financed entirely with 2,592,000 shares of common stock selling at $103.68 per share. CITY normally pays 100% of its earnings as dividends each year and paid $7.776 per share as dividends last year. During an important meeting with the Board of Directors, Alan Ko, one of the Directors, proposes to retire 25.92 million dollars of CITY’s common stock and replace it with 5% long-term debt. As a finance manager in CITY, you are instructed by your boss to evaluate this proposed change in capital structure. It is reported that the P/E ratio of CITY is 17.28.
Required:
Ignore taxes and assume no growth for CITY. Please use the above information on CITY to justify whether the Modigliani & Miller (M&M) propositions are valid in this case. Please explain

Robert · Accepted Answer

A company finances the operations either by equity or by debt or by the combination of both. 
The company’s capital structure can have equity or debt component in majority. Every approach 
has its own advantages and their own disadvantages. There are many theories which try to build 
a relationship between a company’s financial leverage and its market value. MM Approach is 
one of them. 
MM APPROACH HAS TWO PROPOSITIONS WITHOUT TAXES:- 
Proposition 1: According to “No Taxes” assumption, the capital structure of a company does not 
affect the valuation of the firm. In different words, leveraging company doesn’t increase the 
market value of the company.

CITY Manufacturing Company, ‘CITY’, is financed entirely with 2,592,000 shares of common stock selling at $103.68 per share. CITY normally pays 100% of its earnings as dividends each year and paid...

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