Question

The Kimberly Corporation is currently a zero growth firm with an expected EBIT of $100,000 and zero debt financing, and the cost of equity to an unleveled firm in the same risk class is 16.0 percent.

(a). No taxes are currently imposed on Kimberly’s earnings. What is the value of the

       firm (V_U )?

(b) Now, assume that Kimberly still pays no taxes but now decides to use $500,000   

      of 12.0 percent debt financing. Write down (do not calculate) the value of the

     firm according to the MM specification and explain (in one, very short sentence)

     why you can do so.

(c) At the level of debt in part (b) (i.e. $500,000), Kimberly’s cost of levered                                             

     equity (R_E,L) = 32%.

      (i) By considering the cash flow to equity investors in firm L, calculate the value of this

           levered firm’s equity (E_L), and show that   V_L = E_L + D.

      (ii) Name (i.e., write down) the MM proposition that was used to calculate R_E,L.

Answer 1

EBIT = $100,000

cost of equity(unleveled firm) = 16%

(a) No taxes are currently imposed on Kimberly’s earnings. What is the value of the

       firm (V_U )?

unleveled firm (no Interest)

No taxes

so EBIT =  

value of the firm (V_U ) = Cash flow of the firm / cost of equity

= 100,000 / 16%

value of the firm (V_U ) = 625,000

b) The Modigliani-Miller theorem states that in absence of taxes and .., the value of the firm is unaffected by how firm is financed. use $500,000 of 12.0 percent debt financing not change in firm value. In addition, if we take leverage we get tax benfit on interest benefit. Therefore value of firm is unchanged with use of debt that is 625,000

c)(i)

Debt (D) = $500,000

cost of levered = 12%, equity (R_E,L) = 32%

Interest = 500,000*12% = 60,000

Cash flow of the firm = 100,000 - 60,000 = 40,000

value of this levered firm’s equity (E_L) = 40,000 / 32% = 125,000

show that   V_L = E_L + D

levered firm’s equity (E_L)

value of firm = 125,000 + 500,0000

= 625,000

Hence value of the firm (V_U ) = E_L + D

(ii) MM proposition that was used to calculate R_E,L.

Cost of equity = cost of Firm(unlevered) + Debt to equity ratio*(cost of Firm(unlevered) - cost of debt)

Cost of equity = 16% + 500,000/125,000*(16%-12%)

Cost of equity = 16% + 4(4%)

Cost of equity = 32%