Question

Companies U and L are identical in every respect except that U is unlevered while L has $12 million of 7% 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 $5 million. (4) The unlevered cost of equity is 10%. 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 What is rs for Firm U? Round your answer to one decimal place. % What is rs for Firm L? Do not round intermediate calculations. Round your answer to one decimal place. % Find SL, and then show that SL + D = VL 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. SL = $ million SL + D = $ million 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

1. Value of the unlevered firm can be calculated as follows

VU = (EBIT *(1-Tax))/Cost of equity

VU = (5000000*(1-40%))/10% = 3000000/10% = 30,000,000 VU = 30 million

VU = 30000000

VU = 30Million

2. Value of the levered firm can be calculated

VL = (5000000 - 0.007(12000000)/10%

     = (5000000 – 84000)/10%

    = (49160000)

VL = 12000000+49160000

    = 61160000

VL = 61 Million

3. SL + D = VL

VL = VU + TD

        = 30 Million + .40(12Million)

        =30 Million + 4.8 Million

        =34.8 Million

SL = VL – D

        = 34.8 Million – 12 Million

        = 22.8 MIllion