Question
In: Finance
Assume the following data for two firms (U = unlevered firm) and (L = levered firm)....
Assume the following data for two firms (U = unlevered firm) and (L = levered firm). Assume the two firms are in the same risk class when it comes to business risk. Both firms have EBIT = €1000 000. Firm U has zero debt and its required rate of return (KsU = 12%). Firm L has €2000 000 debt and pays 10% interest rate.
Based on the data provided, answer the following questions and show all your computations and interpret your results.
- Find the value of unlevered (U) and levered (L) firms under zero corporate tax assumption.
- Find the market value of the firm’s L’s debt and equity.
- Estimate the cost of capital and the WACC for the unlevered firm.
- Do 1 and 2 under the assumption of corporate tax = 60%.
Solutions
Expert Solution
Where there is no tax
Where thare is no corporate tax , value of levered firm = value of unlevered firm
Value of unlevered form = EBIT/Required rate of return ( Since there is no tax PAT = EBIT)
= €1000 000/ 12%
= €8333333.33
Thus value of levered firm = €8333333.33
Value of equity + Value of debt = Value of firm
Thus €8333333.33 = Value of equity + €2000 000
Thus market value of equity of levered firm = €6333333.33
Market value of equity of levered firm = €2000 000
Where there Corporate tax = 60%
Value of unlevered firm = EBIT(1-tax rate)/Required rate of return
=€1000 000(1-60%)/12%
=€1000 000(0.4)/12%
= 40000/12%
=333333.33 €
Value of levered firm = Value of unlevered firm+ PV of interest shield
= 333333.33 € + (Loan amount x tax rate)
333333.33 € + (2000000 x 60%)
=333,333.33 + 1200,000
= 4533,333.33 €
Value of equity + Value of debt = Value of firm
Thus 4533,333.33 = Value of equity + €2000 000
Thus market value of equity of levered firm = €2533333.33
Market value of equity of levered firm = €2000 00
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