Answered

Explore Westonci.ca, the top Q&A platform where your questions are answered by professionals and enthusiasts alike. Discover a wealth of knowledge from experts across different disciplines on our comprehensive Q&A platform. Explore comprehensive solutions to your questions from knowledgeable professionals across various fields on our platform.

Companies U and L are identical in every respect except that U is unlevered while L has $16 million of 7% bonds outstanding. Assume: (1) All of the MM assumptions are met. (2) Both firms are subject to a 25% federal-plus-state corporate tax rate. (3) EBIT is $2 million. (4) The unlevered cost of equity is 10%.

Required:
a. What value would MM now estimate for each firm?
b. What is rs for Firm U? For Firm L?
c. Find SL, and then show that SL + D= VL results in the same value as obtained in part a.
d. What is the WACC for Firm U? For Firm L?

Sagot :

Answer:

a. Firm U value = $15 million; and Firm L value = $19 million.

b. rs for Firm U = 10%; and rs for Firm L = 22%.

c. Value of levered firm = VL = SL + D => $19 million = $3 million + $16 million

d. WACC for Firm U = 10%; and WACC for Firm L = 7.89%

Explanation:

rd = cost of debt = 7%

r0 = Unlevered cost of equity = 10%

a. What value would MM now estimate for each firm?

Firm U value = Value of unlevered firm = EBIT(1 – Tax rate ) / Unlevered cost of equity = (2 * (1 – 0.25)) / 0.1 = $15 million

Firm L value = Value of levered firm = Value of unlevered firm + (Debt * Tax rate) = 15 + (16 * 25%) = $19 million

This implies that:

SL = Value of equity = Value of levered firm – Debt = $19 – 16 = $3 million

b. What is rs for Firm U? For Firm L?

rs for Firm U = r0 = Unlevered cost of equity = 10%

rs for Firm L = r0 + (r0 – rd)(D / S)(1 – Tax rate) = 10% + (10% - 7%)*(16 / 3)*(1 - 0.25) = 22%

c. Find SL, and then show that SL + D= VL results in the same value as obtained in part a.

Interest = ($16 * 7%) = $1.12 million

Earning before tax = EBIT – Interest = $2 – $1.12 = $0.88 million

Tax = 0.88 * 25% = $0.22 million

Net income = Earning before tax – Tax = $0.88 - $0.22 = $0.66 million

SL = Value of equity = Net income / rs for Firm L = 0.66 / 22% = $3 million

D = $16 million

Value of levered firm = VL = SL + D => $19 million = $3 million + $16 million

d. What is the WACC for Firm U? For Firm L?

WACC for Firm U = r0 = 10%

WACC for Firm L = rs * (SL / VL) + rd * (D / VL) * (1 – Tax rate) = (22% * (3 / 19)) + (7% * (16 / 19) * (1-0.25)) = 7.89%

Thank you for visiting. Our goal is to provide the most accurate answers for all your informational needs. Come back soon. Thank you for your visit. We're dedicated to helping you find the information you need, whenever you need it. Thank you for choosing Westonci.ca as your information source. We look forward to your next visit.