Question

Levered, Inc. and Unlevered, Inc. are identical in every way except for their capital structures. Each company expects to earn $29 million before interest per year in perpetuity, with each company distributing all of its earnings as dividends. Levered's perpetual debt has a market value of $91 million and costs 8 percent per year. Levered has 2.3 million shares outstanding, currently worth $105 per share. Unlevered has no debt and 4.5 million shares outstanding, currently worth $80 per share. Neither firm pays taxes. Suppose you were considering purchasing stock in one of these companies. Which firm's equity shares represent a better value? Equity shares in the unlevered firm are the better buy. The answer cannot be determined from the information provided. Equity shares in the two firms are of equal value. Equity shares in the levered firm are the better buy.

Answer 1

Value of unlevered firm = no. of shares*price per share = 4.5 million shares*$80

= $360 million

As per Modigliani- Miller proposition I value of levered firm (in the absence of tax) = value of an identical unlevered firm

Thus value (or market value) of levered firm = $360 million

No. of shares outstanding of levered firm = 2.3 million

Thus market value of equity of levered firm = 2.3 million shares*$105 = $241.50 million

Now, value of firm = market value of debt+market value of equity

So, value = $91 million+$241.50 million

= $332.50 million

For MMI to hold the value of the levered firm should be $360 million (same as the value of the unvelered firm)

Difference = $360 million - $332.50 million

= $27.5 million

Thus the market value of the levered firm<the market value of the unlevered firm. This makes the levered firm underpriced, on a relative basis.

Therefore the answer is "Equity shares in the levered firm are the better buy"