Question

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 of $10,550,000 should be entered as 10.55. Round your answers to two decimal places. Company U: $ million

Company L: $ million

b.)

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. %

c.) 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

d.)

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

Given data,

A)Company u : unlevered

Ebit is = $ 5 million

Cost of equity of company u = 0.12

Company l : levered

Debt = $ 10 million

Ebit = $ 5 million

There are no taxes therefore value of unlevered firm = value of levered firm

Value of unlevered firm = value of company u

= ebit/cost of equity

= $ 5 million / 0.12

= $41,666,667

Therefore value of levered firm also $ 41,666,667

Value of company u =$41,666,667

Value of company l = $ 41,666,667

B) return on equity of firm u = cost of equity for firm u

= 0.12

Return on equity for firm l

= ( cost of equity of unlevered firm * equity/value of the firm)+( ( cost of equity of unlevered firm - cost of debt)* debt/ value of firm )

= (0.12* $ 31,666,667/$41,666,667 ) + ((0.12 - 0.06 ) * ($10000000/41,666,667)

= 0.0912 + 0.0144

= 0.1056

C) equity portion of firm l

= value of firm l - value of debt

= $ 41,666,667 - 10000000 = 31,666,667

D) wacc of firm u=

((cost of Equity*Equity/ Value of firm) + [Cost of debt*debt/ value of firm]

= (0.12* $41,666,667/$41,666,667)+(0*0/41666667)

= 0.12

Wacc of firm l =

cost of Equity*Equity/ Value of firm) + [Cost of debt*debt/ value of firm]

= ( 0.1056 * 31666667/41666667 )+( 0.06 * 10000000/41666667)

= 0.08025 + 0.01439

= 0.09464

This implies VU is not equal to VL

Where there are no taxes, VU shall equal VL. Consequently, the values are not consistent with the equilibrium.