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 $9 million of 6% bonds outstanding. Both firms have an EBIT of $2 million. Assume that all of the MM assumptions are met.

a.Suppose that both firms are subject to a 40% federal-plus-state corporate tax rate, investors in both firms face a tax rate of Td = 28% on debt income and Ts = 20% (on average) on stock income, and the appropriate required pre-personal-tax rate rsU is 10%.What is the value of the unlevered firm, VU? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

What is the value of the levered firm, VL? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

What is the gain from leverage? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

b.Now keep the other assumptions (D = $9 million, rd = 6%, EBIT = $2 million, and rsU = 10%) but set Tc = Ts = Td = 0. What is the value of the unlevered firm, VU? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

What is the value of the levered firm, VL? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

What is the gain from leverage? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

c.Keep the other assumptions (D = $9 million, rd = 6%, EBIT = $2 million, and rsU = 10%) but now suppose Td = Ts = 0 and Tc = 40%. What is the value of the unlevered firm, VU? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

What is the value of the levered firm, VL? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

What is the gain from leverage? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

d.Keep the other assumptions (D = $9 million, rd = 6%, EBIT = $2 million, and rsU = 10%) but now suppose that Td = 28%, Ts = 28%, and Tc = 40%. Now what is the value of the levered firm? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

What is the gain from leverage? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ million

Explanation / Answer

a) the value of the unlevered firm, VU=EBIT *(1-corporate tax rate)/rsU =$2 million*(1-.4)/.10=2*.6/.10=$ 12 million

Interest on Bonds=.06*9=.54 million

Tax savings=.54 million*.28=0.1512 million

the gain from leverage=Total Tax savings=0.1512 million/.06=2.52 million

the value of the levered firm, VL=VU+ Total Tax savings=$ 12 million+ $2.52 million =$ 14.52 million

b) Tc = Ts = Td = 0

the value of the unlevered firm, VU=EBIT *(1-corporate tax rate)/rsU =$2 million*(1-0)/.10=2/.10=$ 20 million

Interest on Bonds=.06*9=.54 million

Tax savings=.54 million*0=0 million

the gain from leverage=Total Tax savings=0

the value of the levered firm, VL=VU+ Total Tax savings=$ 20 million+ 0 million =$ 20 million

c) Td = Ts = 0 and Tc = 40% =corporate tax rate

the value of the unlevered firm, VU=EBIT *(1-corporate tax rate)/rsU =$2 million*(1-.4)/.10=2*.6/.10=$ 12 million

Interest on Bonds=.06*9=.54 million

Tax savings=.54 million*0=0.1512 million

the gain from leverage=Total Tax savings=0/.06=0 million

the value of the levered firm, VL=VU+ Total Tax savings=$ 12 million+0million =$ 12 million

d) Td = 28%, Ts = 28%, and Tc = 40% the stock income tax has no effect.

the value of the unlevered firm, VU=EBIT *(1-corporate tax rate)/rsU =$2 million*(1-.4)/.10=2*.6/.10=$ 12 million

Interest on Bonds=.06*9=.54 million

Tax savings=.54 million*.28=0.1512 million

the gain from leverage=Total Tax savings=0.1512 million/.06=2.52 million

the value of the levered firm, VL=VU+ Total Tax savings=$ 12 million+ $2.52 million =$ 14.52 million

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