Companies U and L are identical in every respect except that U is unlevered whil

Question

Companies U and L are identical in every respect except that U is unlevered while L has:

$10 million of 5% 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.

(4) The unlevered cost of equity is 10%.

a. What value would MM now estimate for each firm? (Hint: Use Proposition I.)

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

Please how Excel syntax/formula for answer

Explanation / Answer

a) U L EBIT 2000000 2000000 Interest (10000000*5%) 500000 EBT 2000000 1500000 Tax at 40% 800000 600000 NI 800000 600000 Value of Firm U = 800000/10% = 8000000 Answer Value of Firm L = VU+B*t where B=borrowings and t=tax rate VL = 8000000+10000000*40% = 12000000 Answer b) rs = NI/Value of equity rs for firm U = 800000/8000000= 10.00% Answer Value of equity for L = Value of firm-Value of debt = 12000000-10000000 = 2000000 rs for firm L = 600000/(2000000) = 30.00% Answer c) Question not clear. d) WACC: For firm U = 10% For firm L: = 30*2/12+10*60%*10/12 = 10%

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