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

a) EBIT = 100,000 | Cost of Unlevered Equity = 16%

Assuming no taxes, EBIT becomes the Cashflow to the firm.

Value of the Firm (Vu) = CF / R = 10000 / 16% = $625,000

b) The Proposition 1 of the MM theorem states that capital structure of any firm doesn't affect its value, hence, leveraging the firm with a debt of 500,000 at 12% cost will not change firm's value. As in a perfectly efficient market, companies don't have to pay which takes away the benefits of tax shields created by interest payments. Therefore, the Value of the Levered fim is same as Value of the Unlevered firm, that is, $625,000.

c)

i) Debt = 500,000 | Cost of debt = 12%

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

Cashflow to Equity investors = EBIT - Interest payments = 100,000 - 60,000 = 40,000

Using the Cost of levered equity of 32%, we can calculate the value of firm's levered equity.

Value of levered firm's equity = CF / R = 40,000 / 32% = 125,000

As Debt is 500,000, therefore, Value of Unlevered firm = Value of levered firm's equity + Debt

Value of Unlevered firm = 125,000 + 500,000 = 625,000 (We already know that Value of Unlevered firm is 625,000, therefore, result of this equation proves that debt has no effect on firm's value)

Hence, Proved that V_U = E_L + Debt

ii) MM Theorem's Proposition 2 has been used for the calculation of Cost of equity or R_E,L of 32%

It states that cost of equity of a firm is directly proportional to firm's leverage. If firm increases its leverage then it increases its chances of its default, therefore, investors asks higher return for the higher risk.

Cost of Equity = Cost of Unlevered Firm + Debt to Equity ratio * (Cost of Unlevered firm - Cost of Debt)

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

Cost of levered equity = 32%