Question

Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corp. is an unlevered firm, and R Inc. is a levered firm with debt of $5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of $2 million and a marginal corporate tax rate of 40%. Q Corp. has a cost of capital of 15%. (20 marks total)

a. What is Q’s firm value?

b. What is R’s firm value?

c. What is R’s equity value? (1 mark)

d. What is Q’s cost of equity capital? (1 mark)

e. What is R’s cost of equity capital?

f. What is Q’s WACC? (1 mark)

g. What is R’s WACC?

h. Compare the WACC of the two companies. What do you conclude? (1 mark)

i. What principle have you proven in this case? (1 mark)

j. Both companies are now evaluating a project that requires an initial investment of $1.15 million and that will yield cash inflows of $500,000 per year for the next three years. Assume that this project has the same risk level as the individual firm’s assets. Should Q invest in this project? Should R invest in this project?

k. Based on your results for part

(j), discuss the effects of leverage and its tax shields effects on the future value of the two firms. (1 mark)

Q corp - Calculation of Equity EBIT 2,000,000 Less : Interest - EBT 2,000,000 Less : Tax @ 40% 800,000 Earning after Tax 1,200,000 Cost of Capital 15% Equity = Earning / Cost of Cap 8,000,000 So total value of Q firm is 8 Million it also means that total investment in R is also 8 Million out of which 5 Million from Debt and 3 Million from Equity R corp - Income Statement EBIT 2,000,000 Less : Interest @ 10% on 5 Million 500,000 EBT 1,500,000 Less : Tax @ 40% 600,000 Earning after Tax 900,000 Value of Equity 3,000,000 Cost of Equity 30% WACC of R will be as under Debt 6% 5,000,000 300,000 Equity 30% 3,000,000 900,000 8,000,000 1,200,000 WACC 15% I had replied your point a to g, in case of further requirement, you may ask for particular points to answer

I would appreciate the answer to f-j of the above question. The paragraph that is BOLD is partical answer given. I would appreciate the rest of the answer to this answer version - thank you!

Answer 1