Question

Please just answer letters h - k.

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%.

a. What is Q’s firm value?

b. What is R’s firm value?

c. What is R’s equity value?

d. What is Q’s cost of equity capital?

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

f. What is Q’s WACC?

g. What is R’s WACC?

h. Compare the WACC of the two companies. What do you conclude?

i. What principle have you proven in this case?

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

Answer 1

The values are summarised in the table below

	Q	R
EBIT	2000000	2000000
Less Int	0	500000
EBT	2000000	1500000
Less Tax	800000	600000
PAT	1200000	900000
Value of Equity	8000000	5000000
Value of firm	8000000	10000000
Cost of Equity	0.15	0.18
WACC	0.15	0.12

h) Comparing the values of the two companies, it can be concluded that addition of debt increases the cost of equity but reduces the overall cost of Capital (WACC).

i) The principle of firm's value of MM theory with taxes is proven in the case

j) NPV for Q = -1150000+ 500000/1.15+500000/1.15^2+500000/1.15^3 = -$8387.44

As the NPV is negative for Q, Q should not invest in the project

NPV for R = -1150000+ 500000/1.12+500000/1.12^2+500000/1.12^3 = $50915.63

As the NPV is positive for R, R should invest in the project

k) Leverage increases the cost of equity thereby compensating for lower cost of debt. However, the tax shield increases the value of the levered firm as compared to the unlevered firm.

The same also holds for future value of the firm. The levered firm (R) having lower WACC, can undertake projects which are not financially feasible for unlevered firm (Q). Thus, the Levered firm becomes more competitive increasing its future value more than that of Unlevered firm