MM with Corporate Taxes Companies U and L are identical in every respect except
ID: 2709078 • Letter: M
Question
MM with Corporate Taxes
Companies U and L are identical in every respect except that U is unlevered while L has $18 million of 8% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both firms are subject to a 35% federal-plus-state corporate tax rate, (3) EBIT is $3 million, and (4) the unlevered cost of equity is 10%.
What value would MM now estimate for each firm? (Hint: Use Proposition I.) 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.
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.
%
Find SL, and then show that SL + D = VL 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.
SL = $ million
SL + D = $ million
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
EBIT= 3 m- taxes @ 35% of 3 m=1.95 m Value of Firm U(Unlevered-Only Equity)= EBIT/Cost of Equity= 1.95/0.1= 19.5 m Value of Firm L (Levered-Debt& Equity)= EBIT= 3 M Less Int. on Debt 18M *8% 1.44 M EBT 1.56 M Less:Tax @ 35% 0.546 M Earnings to Equity 1.014 Value of Equity= According to proposition 1 of MM Value of Levered firm V(L)= Value of Unlevered firm V(U)+ Tax rate*Debt = 19.5+( 0.35*18) V(L)= 25.8 m Equity S(L)= 25.8- 18= 7.8 m Company U $ 19.5 million Company L $ 25.8 million R(S)- Return on Equity for firm U 1.95m/19.50M 10 % R(S)- Return on Equity for firm L 1.014m/7.8 13 % WACC for Firm U (Full Equity) = 10% WACC for Firm L = 7.8/25.8*0.10 + 18/25.8*0.08 ie. 8.60%
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.