expected return with and without expansion

Question 2

Ahmad Al-Abab is the founder and CEO of UM Corp, a regional company that that opera operates tes severa severall educat education ional al and traini training ng servic services es !he compan company y plans to open more agencies and the success of the ne" agencies "ill depe depend nd on the the stat state e of the the econ econom omy y over over the the ne#t ne#t fe" fe" year years s !he !he company currently currently has a bond issue outstanding "ith a face value of $M%& million that is due in one year Covenants associated "ith this bond issue proh prohib ibit it the the issu issuan ance ce of any any addi additi tion onal al debt debt 'enc 'ence, e, the the comp compan any( y(s s e#pa e#pans nsio ion n must must be enti entirrely )nan )nance ced d "ith "ith e*ui e*uity ty at a cost cost of $M+% $M+%& & million !he table belo" sho"s the value of the company in each state of  the economy ne#t year, both "ith and "ithout e#pansion

a. Calculate the e#pected value of the company and the e#pected value of the company(s debt in one year, "ith and "ithout e#pansion/  !he e#pected value of of the company "ithout "ithout e#pansion is 01 34$M%4 million. 5 64$M74 million. 5 24$M+42 million. 01 $M+& million 5 $M36 million 5 $M248 million 01 $M738 million And the value of the company "ith e#pansion is 01 34$M%% million. 5 64$M92 million. 5 24$M+2& million. 01 $M+9& million 5 $M8% million 5 $M26% million 01 $M9+8 million  !he value of the company(s debt "ith lo" economic gro"th is the value of  the company because the company value is less $M%4 million and $M%% millio million. n. than than the face value value of the debt $M%& $M%& million. million. :n both both other other economic states, the value of the debt is the face value of the debt ;o,  !he e#pected value of of the company(s debt in one year "ithout e#pansion e#pansion is 01 34$M%4 million. 5 64$M%& million. 5 24$M%& million. 01 $M+& million 5 $M38 million 5 $M+3% million 01 $M%6% million And the value of the company(s debt in one year "ith e#pansion is 01 34$M%% million. 5 64$M%& million. 5 24$M%& million. 01 $M+9& million 5 $M38 million 5 $M+3% million

01 $M%78 million b. E#plain "hether the company(s stocy e#panding "ith cash on hand, current stoc
c. 'o" does the e#istence of )nancial distress costs and agency costs a=ect Modigliani and Miller(s theory of capital structure in a "orld "here corporations pay ta#es/ Modigliani and Miller(s theory "ith corporate ta#es indicates that, since there is a positive ta# advantage of debt, the )rm should ma#imi?e the amount of debt in its capital structure :n reality, ho"ever, no )rm adopts an all-debt )nancing strategy MM(s theory ignores both the )nancial distress and agency costs of debt !he marginal costs of debt continue to increase "ith the amount of debt in the )rm(s capital structure so that, at some point, the marginal costs of additional debt "ill out"eigh its marginal ta# bene)ts !herefore, there is an optimal level of debt for every )rm at the point "here the marginal ta# bene)ts of the debt e*ual the marginal increase in )nancial distress and agency costs