Companies U and L are identical in every respect except that U is unlevered whil
ID: 2714973 • Letter: C
Question
Companies U and L are identical in every respect except that U is unlevered while L has $11 million of 7% bonds outstanding. Assume that (1) there are no corporate or personal taxes, (2) all of the other MM assumptions are met, (3) EBIT is $2 million, and (4) the cost of equity to Company U is 10%.
a. What value would MM estimate for each firm? 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.
b. What is rs for Firm U? Round your answer to two decimal places.
_____ %
What is rs for Firm L? Do not round intermediate calculations. Round your answer to two decimal places.
_____ %
c. Find SL. Round your answer to two decimal places. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000.
$ _____ million
d. What is the WACC for Firm U? Round your answer to one decimal place.
_____ %
What the WACC for Firm L? Round your answer to one decimal place.
_____ %
Suppose VU = $20 million and VL = $22 million. According to MM, are these values consistent with equilibrium?
-Select- Yes or No
Explanation / Answer
Answer to sub part a:
Given data,
Company U : Unlevered
EBIT = $2million
Cost of equity of Company U = 0.1
Company L : Levered
Debt = $11 million
EBIT = $2 million
There are no taxes. Therefore, value of unlevered firm = value of levered firm
Value of unlevered firm = Value of Company U
=EBIT/ Cost of equity
=$2million / 0.1
=$20 million
Therefore value of Levered firm = Value of Company L = $20 million
Value of Company U =$ 20
Value of Company L = $20
Answer to sub part b:
rs means Return on equity.
rs for Firm U = Cost of equity of firm U
= 0.1
rs for Firm L
=(cost of Equity of unlevered firm*Equity/ Value of firm) + [(Cost of equity of unlevered firm-Cost of debt)*debt/ value of firm]
=(0.1*$9million/$20 million) + [(0.1-0.07)*$11million/$20 million]
=0.045 + 0.0165
=0.0615
rs of Firm U = 0.1
rs of Firm L = 0.0615
Answer to sub part c:
SL means Equity portion of levered firm
Therefore SL = Equity portion of Firm L
= Value of firm - Value of debt
= $20 million - $11 million
= $ 9 million
SL = $9million
Answer to sub part d:
Computation of WACC for firm U:
WACC= (cost of Equity*Equity/ Value of firm) + [Cost of debt)*debt/ value of firm]
=(0.1*$20 million/$20 million) + [0*0/$20 million]
=0.1 + 0
=0.1
Computation of WACC for firm L:
WACC= (cost of Equity*Equity/ Value of firm) + [Cost of debt*debt/ value of firm]
=(0.615*$9million/$20 million) + [(0.07)*$11million/$20 million]
=0.02025 + 0.0385
=0.05875
WACC of Company U = 0.1
WACC of Company L =0.05875
VU= $20 million, VL =$22 million. This implies VU is not equalto VL
Where there are no taxes, VU shall equal VL. Hence the values are not consistent with equilibrium.
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