ABC Drilling has debt with a market value of $200,000 and a yield of 9%. The firm's equity has a market value of $300,000, its earnings are growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what would ABC Drilling’s total value be if it had no debt?
To calculate ABC Drilling's total value if it had no debt using the Modigliani-Miller (MM) extension with growth, we need to follow these steps:
Step 1: Calculate the cost of equity (Ke) for ABC Drilling using the Capital Asset Pricing Model (CAPM) formula:
Ke = Rf + βe * (Rm - Rf)
Where:
- Rf is the risk-free rate of return,
- βe is the equity beta, and
- (Rm - Rf) is the market risk premium.
However, in this case, we were provided with the cost of equity for a similar firm with no debt, which is 12%. So we can directly use this value for Ke.
Ke = 12%
Step 2: Calculate the present value of the firm's free cash flows to equity (FCFE) using the Gordon Growth Model:
FCFE = (Earnings * (1 - Tax Rate)) * (1 - Growth Rate) / (Ke - Growth Rate)
Where:
- Earnings is the current earnings of ABC Drilling,
- Tax Rate is the firm's tax rate,
- Growth Rate is the rate at which earnings are growing, and
- Ke is the cost of equity.
From the given information, we know that ABC Drilling's earnings are growing at a 5% rate and the tax rate is 40%. However, we were not provided with the current earnings value. Without this information, it is not possible to calculate the FCFE and proceed further.
Therefore, with the information given in the question, it is not possible to determine ABC Drilling's total value if it had no debt using the MM extension with growth.