Question

In: Finance

Delta Mills and Franklin Mills are identical firms except for their capital structures. Delta is an...

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

Solutions

Expert Solution

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.

If you are having any doubts,please post a comment.

Thank you.Please rate it.

jeff jeffy answered 1 year ago
Next > < Previous

Related Solutions

ABC and XYZ are identical firms in all respects except for their capital structures. ABC is...
ABC and XYZ are identical firms in all respects except for their capital structures. ABC is all-equity financed with $530,000 in stock. XYZ has the same total value but uses both stock and perpetual debt; its stock is worth $310,000 and the interest rate on its debt is 7.9 percent. Both firms expect EBIT to be $62,222. Ignore taxes. The cost of equity for ABC is ________ percent and for XYZ it is ________ percent. Select one: A. 12.09; 12.48...
ABC co. And XYZ co. are identical firms in all respects except for their capital structures....
ABC co. And XYZ co. are identical firms in all respects except for their capital structures. ABC is all-equity financed with $650,000 in stock. XYZ uses both stock and perpetual debt, it’s stock is worth $325,000 and the interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes A.) Richards owns $39,000 worth of XYZ’s stock. What rate of return is he expecting? B.) Suppose Richard invests in ABC co. and uses homemade...
Levered, Inc. and Unlevered, Inc. are identical in every way except for their capital structures. Each...
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...
ABC and XYZ are identical firms in all respects except for their capital structure. ABC is...
ABC and XYZ are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 10%. Both firms expect EBIT to be $95,000 and all income will be distributed as dividends. Ignore taxes. a. Richard owns $30,000 worth of XYZ stock. What rate of return is he expecting? b. Show how Richard...
ABC and XYZ are two identical firms except for their capital structure. The share price for...
ABC and XYZ are two identical firms except for their capital structure. The share price for both of firms is $10. ABC is an all equity firm. XYZ has D/E of 0.8. Investor A bought 100 shares of XYZ with his own money since he believes the levered firm will provide better return. If you decide to use homemade leverage to show him that leverage doesn’t matter, what would be your trading strategy? Please be specific (i.e. how much money...
Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation,...
Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 14,500 shares of stock outstanding, currently worth $20 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $64,500, and its cost of debt is 8 percent. Each firm is expected to have earnings before interest of $74,500 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 8 percent...
Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company...
Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $29.3 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual debt has a market value of $94 million and costs 8 percent per year. Levered has 2.6 million shares outstanding, currently worth $108 per share. Unlevered has no debt and 4.8 million shares outstanding, currently worth $83 per share. Neither firm pays...
Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company...
Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $12 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual debt has a market value of $68 million and costs 4 percent per year. Levered has 2.6 million shares outstanding that sell for $84 per share. Unlevered has no debt and 4.3 million shares outstanding, currently worth $69 per share. Neither firm...
Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation,...
Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 9,200 shares of stock outstanding, currently worth $22 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $50,000, and its cost of debt is 13 percent. Each firm is expected to have earnings before interest of $62,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 13 percent...
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure....
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $73,000. Ignore taxes. A) You own $56,250 worth of XYZ’s stock. What rate of return are you expecting? B) Calculate the cash flows and rate of return...
ADVERTISEMENT
Subjects
ADVERTISEMENT
Latest Questions
ADVERTISEMENT