Companies U and L are identical in every respect except that U is unlevered whil
ID: 2468902 • Letter: C
Question
Companies U and L are identical in every respect except that U is unlevered while L has $12 million of 6% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both firms are subject to a 40% federal-plus-state corporate tax rate, (3) EBIT is $2 million, and (4) the unlevered cost of equity is 12%. a. What value would MM now estimate for each firm? Enter your answers in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1, 200,000. Round your answers to two decimal places. Company U Company L b. What is rs for Firm U? Round your answer to one decimal place. What is rs for Firm L? Do not round intermediate calculations. Round your answer to one decimal place. c. Find S_L, and then show that S_L + D = V_L results in the same value as obtained in part a. Enter your answers in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1, 200,000. Do not round intermediate calculations. Round your answers to two decimal places. S_L = S_L + D = d. What is the WACC for Firm U? Do not round intermediate calculations. Round your answer to two decimal places. What is the WACC for Firm L? Do not round intermediate calculations. Round your answer to two decimal places.Explanation / Answer
Solution:
(a)
As per MM with Corporate Taxes
Value of Levered Firm = Value of Unlevered Firm + Debt x Tax Rate
Therefore,
Value of Company L (Levered) = Value of Company U + Debt x Tax Rate = $10 million + ($12 million x40%) = $10 million + 4.80 Million = 14.80 Million
Value of Company U (Unlevered) = EBIT (1 – Tax) / Cost of Equity = $2 million (1 – 0.40) / 0.12 = $10 million
Value for each firm
Company U = $10 million
Company L = $14.80 Million
(b) ---- What is the meaning of rs --- I do not recognize this work. Can you please advise so that I will give you answer for this part also.
(c) What is the meaning of SL ? please advise so that I can provide you the solution.
(d)
WACC of Firm U = (Cost of Equity x Weight of Equity) + (Cost of Debt x Weight of Debt) = 12% x 1 = 12%
WACC of firm U = 12%
WACC of Firm L = (Cost of Equity x Weight of Equity) + (Cost of Debt x Weight of Debt)
Cost of Equity of Firm L = Earnings attributable for Equity Shareholders / Market Value of Equity x 100
Earnings attributable for Equity Shareholders = (EBIT – Interest on Bond) (1 – Tax Rate) = ($2 million – 0.72 million) (1 – 0.4) = $0.768 Million
Market Value of Equity = Value of Firm L – Value of Bond = $14.80 – 12 = $2.8 Million
Cost of Equity = $0.768 / $2.8 x 100 = 27.43%
Weight of Equity in capital structure = MV of Equity / Total Value of Capital Structure = $2.8 / $14.8 = 0.19
Cost of Debt = Interest Rate (1 – Tax Rate) = 6% (1 – 0.4) = 3.6%
Weight of Debt = Value of Debt / Total Value of Capital Structure = $12 / $14.8 = 0.81
WACC of Firm L = (27.43% x 0.19) + (3.6% x 0.81) = 5.21% + 2.916% = 8.126% or 8.13%
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