You are given the following information: EBIT (for firms L and U in perpetuity)

Question

You are given the following information: EBIT (for firms L and U in perpetuity) = $300,000; corporate tax rate (T) = 30%; cost of equity for firm U (Ksu or rsu) = 10%; cost of debt for firm L (Kd or rd) = 8%; level of debt for firm L (D) = $1,200,000.

What are the WACCs of firms U and  L, respectively, under M&M theory with corporate taxes?

11.33% (U), 10.53% (L)

10%(U), 8.10% (L)

10% (U), 11.33% (L)

10% (U), 8.53% (L)

11.33% (U), 10.53% (L)

10%(U), 8.10% (L)

10% (U), 11.33% (L)

10% (U), 8.53% (L)

Explanation / Answer

For Unlevered firm U, WACC is same as unlevered cost of Equity= 10%

For Levered Firm L :-

Market Value of Firm L = Market Value of Firm U + After Tax Debt = $ 300000(1 - 0.30) / 0.10 + 1200000*30%

= $ 2100000 + 360000

= $ 2460000

Value of L's equity

$ 2460000 = $1200000 + Equity

Equity = $ 1260000

Cost of levered Equity (rSL) = rSU + (rSU - rd)* (1 - t) * D/S

rSL = 10% + ( 10 - 8) ( 1- 0.30) * 1200000/12600000

rSL = 11.33%

WACCL = (D/V)rd(1 - T) + (S/V)rSL

WACCL  = (1200000/2460000) * 0.08 * (1-0.30) + 1260000/2460000 * 11.33%

WACCL  = 8.53%

ANSWER: 10% (U), 8.53% (L)

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