Question

MM with Corporate Taxes

Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 6% bonds outstanding. Assume that: (1) All of the MM assumptions are met. (2) Both firms are subject to a 40% federal-plus-state corporate tax rate. (3) EBIT is $3 million. (4) The unlevered cost of equity is 9%.

1. What value would MM now estimate for each firm? (Hint: Use Proposition I.) Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Round your answers to two decimal places.
   Company U: $ ?? million
   Company L: $ ?? million
   
2. What is r_s for Firm U? Round your answer to one decimal place.
   ?? %
   
   What is r_s for Firm L? Do not round intermediate calculations. Round your answer to one decimal place.
   ?? %
   
3. Find S_L, and then show that S_L + D = V_L results in the same value as obtained in Part a. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answers to two decimal places.
   S_L = $ ?? million
   S_L + D = $ ?? million
   
4. What is the WACC for Firm U? Do not round intermediate calculations. Round your answer to two decimal places.
   ?? %

   What is the WACC for Firm L? Do not round intermediate calculations. Round your answer to two decimal places.
   ?? %

Answer 1

(Fig.in mlns.)

As per MM Proposition 1

a.Value of Company U,Vu=PV of after-tax income=EBIT*(1-Tax rate)/UnL. Cost of Equity=3*(1-40%)/9%=20

Value of Company L=V(L)=V(UL)+Debt*(Tax rate)

ie. 20+(10*40%)=

24

b.

As per MM Proposition 1

Cost of levered Equity=Cost of Unlevered equity+(Debt/Equity*(Cost of UnL. Equity-Cost of Debt)(1-tax rate)

so, rs for Company U= 9%

9.00%

rs for Company L=

Using the above formula,

rs=9%+(10/14*(9%-6%))(1-40%)=

10.29%

c.Value of equity in levered firm,S(L)=Total value-Value of Debt

ie.24-10=14

Debt=10

SL+D=14+10=24

d. WACC for Company U

(Wt. E*rE)+(wt.D*rD*(1-Tc))

ie.(100%*9%)+(0%*0%)=

9.00%

WACC for Company L

(Wt. E*rE)+(wt.D*rD*(1-Tc))

(14/24*10.29%)+(10/24*6%*(1-40%)=

7.50%