Question

Company U and company L are identical in every respect except company U is unlevered and company L has $1,000,000 perpetual debt with an interest rate of 6%. Both companies are expecting to have an EBIT of $300,000 in perpetuity and all earnings will be immediately distributed to common shareholders. Company U has a cost of equity of 10%. Assume that all Modigliani and Miller assumptions are satisfied. Calculate the cost of equity for the levered firm according to MM proposition I without taxes.(Do not round intermediate calculations. Round the final answer to 2 decimal places. Omit the % sign in your response. For example, an answer of 15.39% should be entered as 15.39.)

Answer 1

In absence of tax , value of levered firm = value of unlevered firm

Value of unlevered firm = EBIT/Cost of equity

= 300000/10%

=3000000$

Thus Value of levered firm = $3000,000

Value of equity in levered firm = Value of levered firm - Debt

=3,000,000 -1,000,000

= $ 2,000,000

Cost of equity of levered firm = Ra +D/E(Ra - Rd)

here Ra = Cost of equity of unlevered firm

Rd = cost of debt

D = value of debt

E = value of equity

Thus Cost of equity of levered firm = 10% + 1000000/2000000(10%-6%)

=10% +1/2(4%)

=10% + 2%

= 12%