Question

is unlevered while has 12-13 Comp and are identical in every respect except that $10 million of hands outstanding. Assume that (1) all of the MM assumptions are met, 21 there are no corporate or personal taxes O ESIT is $2 million, and (4) the cost of equity to Company Lis 10 What w e would MM estimale for each firm? b What is t for Firm U7 For Firm Finds, and then show that 5 + D- V - $20 million d. What is the WACC for Firm U7 For Firm L? Suppose V - $20 million and V = $22 million. According to MM, do these values represent an equitibrium? If not, explain the process by which equilibrium would be restond. 12-14 Companies L and L are identical in every respect except that U is unlevered while L has Corpore 510 million of 5 bonds outstanding Assume that (1) all of the MM assumptions are met, ONE (2) both firms are subject to a 40% corporate tax rate, (3) EBIT is $2 million, and (4) the unlevered cost of equity is 10% What value would MM now estimate for each firm? (Use Proposition 1.) b. What is t, for Firm U? For Firm L? c Find 5, and then show that SL+D - Vresults in the same value as obtained in Parta. d. What is the WACC for Firm U? For Firm L? 12:15 Companies Miler Model $10 million of 5% bonds outstanding. Assume that (1) all of the MM assumptions are met, and L are identical in every respect except that U is unlevered while L has (2) both firms are subject to a 40% corporate tax rate, (3) EBIT is 52 million, (4) investors in both firms face a tax rate of T. = 28on debt income and T, = 20%, on average, on stock income, and (5) the unlevered cost of equity, What is the value of the unlevered firm, VU? is 10%. that W cospon dan b. What is the value of V? NEL

Answer 1

12- 13

Company U	Company L
EBIT= $2 million	EBIT= $2 million
Cost of equity = 10%
-	5% Debt = $10 mil
No taxes	No taxes

1. Value of unlevered firm with no tax = EBIT/ Cost of equity

Value of firm for company U= 2000000/10%

= $20,000,000 or $20 million

Value of firm of levered firm = value of unlevered firm + tax rate* value of debt

But for no tax firm , value of levered firm = value of unlevered firm

So value of L= $20 millions

2. ‘rs= r0+ (B/S)(R0-Rb)

Ro= cost of equity

B= value of debt

S= value of equity

Rb= cost of debt

Rs= cost of equity

In case of unlevred firm R0= Rs

So Rs for company U= 10%

Rs for company L= 0.10 + (10000000/20000000)(0.10-0.05)

= 0.10+ (0.5)(0.05)

= 0.125 or 12.50%

3. Market value of Equity = total value of firm- debt

Here for company L

S(L)= 2000000-1000000

= 1000000

Or $10 million

So = S(L) + D= V

= 10 mil + 10 mil = $ 20mil

4. WACC= {kd * debt/ debt+ equity}+ {ke*equity/debt+ equity}

For U WACC= cost of equity = 10%

For L WACC= 5% * 10/(20) + 10%* 10/20

= 0.05*0.5 + 0.1*0.5

= 0.025+0.05

= 0.075 or 7.50%