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 bonds with 5% interest rate. Assume that all of the MM assumptions are met, both firms are subject to a 40% corporate tax rate, EBIT is $2 million, and the unlevered firms cost of equity is 10%.
What is the value of the unlevered firm?
A) $10 million
B) $12 million
C) $16 million
D) $20 million
What is the value of the levered firm?
A) $10 million
B) $12 million
C) $16 million
D) $20 million
What is cost of equity for the levered firm?
A) 5%
B) 10%
C) 15%
D) 6%
What is the WACC for the levered firm?
A) 5%
B) 7.5%
C) 10%
D) 15%

Explanation / Answer

Value of the Unlevered Firm according to MM approach : Vu = EBIT (1-t)/ke ,cost of equity = $2million(1-.40)/.10 = $12million Answer : B $12million Value of the Levered Firm : VL = Vu + Debt tax shields = 12 + 10+(10*.4) = 16 Answer : C $16 million Cost of Equity of Levered Firm : Ke= Net Income after Int and tax/value of levered firm = 2-0.5-.6 = 0.9 Value of unlevered firm = 16-debt 10= 6 Ke = 0.9/6 = 15% Answer = C 15% WACC of Levered Firm : Ko = Cost od debt after tax*debt/value of Lev firm + ke*Value of Unlev/Value of lev firm K0=5(1-.4)*10/16 + 15*6/16 Ko = 7.5% Answer : B 7.5%

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