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 $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 10%.

a.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. Company U $ million Company L $ million

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 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

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

a. Value of Firm U, Vu = EBIT * (1 - Tax rate) / Unlevered cost of equity

= $2 million * (1 - 40%) / 10%

= $12.00 million

Value of Firm L, Vl = Vu + Tax rate * Debt

= $12 million + 40% * $12 million

= $16.80 million

b. rs for Firm U, rsu = unlevered cost of equity = 10%

rs for Firm L, rsl = rsu + (rsu - rd) * (1 - Tax rate) * (Debt / Stock)

= 10% + (10% - 6%) * (1 - 40%) * ($12 million / $4.80 million)

= 16%

c. Value of Stock L, Sl = (EBIT - rd * Debt) * (1 - Tax rate) / rsl

= ($2 million - 6% * $12 million) * (1 - 40%) / 16%

= $4.80 million

Value of Firm L, Vl = Sl + Debt

= $4.80 million + $12 million

= $16.80 million

d. WACCu = 10.00%

WACCl = (Debt / Vl) * rd * (1 - Tax rate) + (Sl / Vl) * rsl

= ($12 million / $16.80 million) * 6% * (1 - 40%) + ($4.80 million / $16.80 million) * 16%

= 7.14%

=> rsl =

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