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

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