Question

Delta Mills and Franklin Mills are identical firms except for their capital structures. Delta is an unlevered firm with $680,000 of equity. Franklin is a levered firm. Both Delta and Franklin have an expected EBIT of $84,000. Delta Mills has a ________ WACC than Franklin Mills and a ______ firm value compared to Franklin.

A. lower; lower

B. higher; higher

C. lower; higher

D. higher; lower

Answer #1

**Answer : D. higher;lower.**

Explanation :

Unlevered firm have only equity which require high required return and levered firm carry debt and equity so cost of debt is lessor than equity so levered firm have lower WACC than unlevered firm.

As the unlevered firm have higher WACC compare to levered firm so it's have higher discounting factor so value of firm from cash flow lower compare to levered firm.

Ex.

Continue forever EBIT of both firm 100 every year and WACC of unlevered firm is 10% and levered firm is 8%

Value of Unlevered firm = 100/10% = 1000

Value of Levered Firm = 100/8% = 1250

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