Question

Delta Mills and Franklin Mills are identical firms except for their capital structures. Delta is an unlevered firm with $680,000 of equity. Franklin is a levered firm. Both Delta and Franklin have an expected EBIT of $84,000. Delta Mills has a ________ WACC than Franklin Mills and a ______ firm value compared to Franklin.

Group of answer choices

a. higher; higher

b.lower; higher

c.lower; lower

d.higher; lower

Answer 1

According to MM Approach

We know that Cost of Equity in a levered Company ( Keg)= K eu+ [( Keu - Kd ) Debt / {Debt + Equity}]

Keg = Cost of Equity in levered company

Keu = Cost of Equity in unlevered company

Kd = Cost of Debt

From the above we can observe that Cost of Capital of levered firm is always greater than the cost of Capital of unlevered firm

Since Delta is a unlevered firm , so it is having a lower WACC when compared to the Franklin mills. Due to presence of Debt in the capital structure of Franklin, Cost of Capital increases. For Franklin

If a firm has lower WACC , then its value increases

Let us suppose the WACC of Delta is 12% and Franklin is 13%

Value of Delta firm = EBIT / Cost of Capital

= $ 84000/0.12

= $ 700000

Value of the Franklin = EBIT / Cost of Capital

= $ 84000/0.13

= $ 646153

So we can observe that Higher WACC reduces the value of the firm.

Delta Mills has a lower WACC, than Franklin mills and a higher value when compared to Franklin. So obtion b ) is the Correct answer.

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