Question

In: Accounting

Firms U and A are similar except that firm U is unlevered, while firm A is...

Firms U and A are similar except that firm U is unlevered, while firm A is a levered and has 5% Debt of 20% in its total capital structure amount of OMR 1,000,000.
​Assume that the corporate tax rate is 40%; net operating income is 20% of total fixed assets and the cost of equity of unlevered firm is 10%. Total fixed assets amount OMR 700,000.
​As finance student, by following Modigliani-Miller Approach estimate the value of the unlevered firm (U) and levered firm (A) and also compute overall cost of capital of levered firm.
​Suppose that if the firm A increases its debt amount to 50% of its total capital structure, then what would be the new equity value of levered firm A, and new cost of equity of levered firm A

Solutions

Expert Solution

Part(a)

Particulars Firm - U Firm - A
(Unlevered) (Levered)
Capital 1000000 1000000
5% Debt (1000000*20%) 200000
Net operating income(20% of fixed asset 700000) 140000 140000
Tax rate 40% 40%
Net operating income(20% of fixed asset 700000) 140000 140000
Less:Interest 10000
Net profit before tax 140000 130000
Less:Tax @40% 56000 52000
Profit available for distribution 84000 78000
Cost of equity 10% 9.17%**
Market value of firm (profit available for distribution/cost of equity) 840000 850906
Total value of firm (Debt+market value of firm) 840000 1050906

Overall cost of capital of levered firm

Weighted Average Cost of Capital=5%*(200000/1200000)+10%*(1000000/1200000)
0.091667
9.17%

Part (b)

Increase in Debt to 50% by Firm -A
Particulars Firm - A
(Levered)
Capital 1000000
5% Debt (1000000*50%) 500000
Net operating income(20% of fixed asset 700000) 140000
Tax rate 40%
Net operating income(20% of fixed asset 700000) 140000
Less:Interest 25000
Net profit before tax 115000
Less:Tax @40% 46000
Profit available for distribution 69000
Cost of equity 35%
Market value of firm (profit available for distribution/cost of equity) 197143
Total value of firm (Debt+market value of firm) 697143

New cost of capital

Weighted Average Cost of Capital=5%*(500000/1500000)+10%*(1000000/1500000)
0.35
35%

ekkarill92 answered 2 years ago
Next > < Previous

Related Solutions

Companies U and L are identical in every respect except that U is unlevered while L...
Companies U and L are identical in every respect except that U is unlevered while L has $8 million of 6% bonds outstanding. Assume: (1) All of the MM assumptions are met. (2) Both firms are subject to a 25% federal-plus-state corporate tax rate. (3) EBIT is $3 million. (4) The unlevered cost of equity is 9%. What value would MM now estimate for each firm? (Hint: Use Proposition I.) Enter your answers in millions. For example, an answer of...
Companies U and L are identical in every respect except that U is unlevered while L...
Companies U and L are identical in every respect except that U is unlevered while L has $8 million of 5% bonds outstanding. Assume that: (1) All of the MM assumptions are met. (2) Both firms are subject to a 35% federal-plus-state corporate tax rate. (3) EBIT is $2 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...
Companies U and L are identical in every respect except that U is unlevered while L...
Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 6% bonds outstanding. Assume: (1) All of the MM assumptions are met. (2) Both firms are subject to a 25% federal-plus-state corporate tax rate. (3) EBIT is $5 million. (4) The unlevered cost of equity is 12%. a.) What value would MM now estimate for each firm? (Hint: Use Proposition I.) Enter your answers in millions. For example, an answer...
Companies U and L are identical in every respect except that U is unlevered while L...
Companies U and L are identical in every respect except that U is unlevered while L has $8 million of 5% bonds outstanding. Assume: (1) All of the MM assumptions are met. (2) Both firms are subject to a 25% federal-plus-state corporate tax rate. (3) EBIT is $2 million. (4) The unlevered cost of equity is 12%. What value would MM now estimate for each firm? (Hint: Use Proposition I.) Enter your answers in millions. For example, an answer of...
Companies U and L are identical in every respect except that U is unlevered while L...
Companies U and L are identical in every respect except that U is unlevered while L has $18 million of 8% bonds outstanding. Assume that: (1) All of the MM assumptions are met. (2) Both firms are subject to a 35% federal-plus-state corporate tax rate. (3) EBIT is $2 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...
Companies U and L are identical in every respect except that U is unlevered while L...
Companies U and L are identical in every respect except that U is unlevered while L has $12 million of 8% 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 $3 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...
Companies U and L are identical in every respect except that U is unlevered while L...
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 all of the original M&M assumptions are met, that EBIT is $3 million for both companies and that the cost of equity to company U is 9%. If there are corporate taxes at the 34% marginal level for both firm's what is the M&M WACC for firm L.
Assume the following data for two firms (U = unlevered firm) and (L = levered firm)....
Assume the following data for two firms (U = unlevered firm) and (L = levered firm). Assume the two firms are in the same risk class when it comes to business risk. Both firms have EBIT = €1000 000. Firm U has zero debt and its required rate of return (KsU = 12%). Firm L has €2000 000 debt and pays 10% interest rate. Based on the data provided, answer the following questions and show all your computations and interpret...
Assume that two firms, U and L, are identical in all respects except for one: Firm...
Assume that two firms, U and L, are identical in all respects except for one: Firm U is debt-free, whereas Firm L has a capital structure that is 50% debt and 50% equity by market value. Further suppose that the assumptions of M&M's "irrelevance" Proposition I hold (no taxes or transaction costs, no bankruptcy costs, etc.) and that each firm will have income before interest and taxes of $800,000. If the required return on assets, rA, for these firms is...
The unlevered cost of capital of a given firm is given by 20%, while its debt...
The unlevered cost of capital of a given firm is given by 20%, while its debt is given by $75,000,000. The pre-tax cost of debt (equal to the risk-free rate) is given by 10%. The levered value of the firm is given by $200,000,000, while its equity value is given by $125,000,000. The tax rate is 20%. The WACC of this firm is given by: Group of answer choices 15.5% 16.5% 17.5% 18.5%
ADVERTISEMENT
Subjects
ADVERTISEMENT
Latest Questions
ADVERTISEMENT