Question

Company A and Company B are identical in every respect except Company A is unlevered and Company B has $1 million of perpetual debt with an interest rate of 6%. Expected EBIT for both firms is $900,000 in perpetuity and all available earnings are immediately distributed to common shareholders. Company A's cost of equity is 18%. Assume all M&M assumptions are satisfied.

For parts (a) to (c), assume there are no personal or corporate taxes
(a) According to M&M Proposition I without taxes, what is the value of each firm?
(b) According to M&M Proposition II without taxes, what is the cost of equity for Company B?
(c) According to M&M Proposition II without taxes, what is the WACC for each firm?

For parts (d) to (f), assume there are no personal taxes but the corporate tax for both companies is 30%
(d) According to M&M Proposition I with taxes, what is the value of each firm?
(e) According to M&M Proposition II with taxes, what is the cost of equity for Company B?
(f) According to M&M Proposition II with taxes, what is the WACC for each firm?

Answer 1

a) According to M&M proposition I without taxes,

   Value of firm = EBIT(1-Tax)- depreciation- Capital expenditure

   Value of both firm A & B = $900000(1-0) = $ 900000

b) According to M&M proposition II without taxes,

   cost of equity for company B (Eb) is, Eb= Ea+ Debt to equity ratio * (Ea-rate to debt) =18 +1 (18-6) =30

c) According to M&M proposition II without taxes,

WACC = Ke*We + Kd*Wd

  WACC for A = 18*1 = 18

WACC for B = 30*0.5 + 6*0.5= 18

d) According to M&M proposition I with taxes,

   Value of firm = EBIT(1-Tax)- depreciation- Capital expenditure

   Value of firm A = $900000(1-0.3) = $ 630000

   Value of firm B = Value of unlevred firm A + Tax * Debt =$630000+ 0.3 * $100000= $660000

e) According to M&M proposition II with taxes,

   cost of equity for company B (Eb) is, Eb= Ea+ Debt to equity ratio * (Ea-Cost to debt) =18 +1 (18-6) =30

f) According to M&M proposition II with taxes,

   WACC = Ke*We + Kd*(1-T)*Wd

Here, Ke= cost of equity, Kd= Cost of debt, We&Wd=weightage of equity & debt respectively

  WACC for A = 18*1 = 18

WACC for B = 30*0.5 + 6*(1-0.3)*0.5= 17.1