Question

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​)?

Answer 1

Answer:

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