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Levered, Inc., and Unlevered, Inc., are identical in every way except their capi

ID: 2720281 • Letter: L

Question

Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $28.9 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual debt has a market value of $90 million and costs 7 percent per year. Levered has 2.2 million shares outstanding, currently worth $116 per share. Unlevered has no debt and 4.4 million shares outstanding, currently worth $78 per share. Neither firm pays taxes.

What is the value of each company's equity?

Explanation / Answer

Unlevered, Inc The value of Unlevered (assets = equity) =78 * 4.4million = $343.2 million Levered, Inc. Since Unlevered and Levered have the same business risk => same return on assets, the total value of Levered (equity + debt) =343.2 Million hence value of equity 343.2-90 =253.20 Undervalued Undervalued by =253.20-(255.20 ie 2.2*116) = 2 million

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