Question

Base Corp and Eastern Tech are two identical companies except for their capital structures. Neither firm pays taxes. Both firms have EBIT of $35,000 in perpetuity.

Base Corp is unlevered and has 5,000 shares outstanding, each worth $20.

Eastern Tech is levered and has $25,000 in debt at a cost of debt of Rd = 12%.

1. How much is Base Corp worth?
2. How much is Eastern Tech worth?
3. What is Eastern Tech’s market value of equity?
4. How much would it cost to buy 30% of each company?
5. Is Eastern Tech more risky than Base Corp? Please explain.

Answer 1

(a): Worth of Base Corp = 5,000 shares * $20 per share = $100,000

(b): Modigliani-Miller Proposition I states that in the absence of taxes, the value of a levered firm equals the value of an otherwise identical unlevered firm. Modigliani-Miller Proposition I (No Taxes):V_L =V_U

Thus worth of Eastern Tech = $100,000

(c ): Value of equity = worth of the company – market value of debt

= 100,000 – 25,000

= $75,000

(d): 30% of Base Corp = 30% of 100,000 = $30,000

30% of Eastern Tech = 30% of $75,000 = $22,500

(e): Yes, Eastern Tech is more risky than Base Corp and this is because of presence of debt. Eastern must pay off its debt holders before its equity holders receive any of the firm’s earnings. If the firm does not do particularly well, all of the firm’s earnings may be needed to repay its debt holders, and equity holders will receive nothing.