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17 February, 17:20

You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $ 31 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $ 2.5 million. Investors are willing to provide you with $ 2.5 million in initial capital in exchange for 25 % of the unlevered equity in the firm. a. What is the total market value of the firm without leverage? b. Suppose you borrow $ 0.8 million. According to MM, what fraction of the firm's equity will you need to sell to raise the additional $ 1.7 million you need? c. What is the value of your share of the firm's equity in cases (a ) and (b ) ?

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  1. 17 February, 20:10
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    The correct answer for option (a) is $10 million, for option (b) is 18.5% and for option (c) is 7.5 million and 7.5 million.

    Explanation:

    A). Without Leverage Total Market Value Of The Firm = Initial Capital : Exchange Rate Of Unlevered Equity

    = $2.5 millions : 25 * 100

    = $10 millions

    B). Balance Equity (According to MM hypothesis) = Without Leverage Total Market Value of the Firm - Borrowings

    = $10 millions - 0.8 millions

    = $9.2 millions

    To raise the balance of $1.7 million, we need to sell equity of the firm

    = $1.7 millions : $9.2 millions

    = 0.185 or 18.5%

    C). Value of the entrepreneur's equity share of the firm in cases (a) and (b) are as follows:

    (A.) 100 - Exchange Rate Of Unlevered Equity * Without Leverage Total Market Value Of The Firm = (100 - 25) % * 10 millions

    = 75% * 10 millions

    = $7.5 millions

    (B.) = 100 - Need To Sell Equity : Balance Equity

    = (100 - 18.5) : $9.2 millions

    = $7.5 millions
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