Problem 21-7 MM with Corporate Taxes Companies U and L are identical in every re
ID: 2734220 • Letter: P
Question
Problem 21-7
MM with Corporate Taxes
Companies U and L are identical in every respect except that U is unlevered while L has $20 million of 5% 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 $4 million, and (4) the unlevered cost of equity is 10%.
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.
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.
%
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
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
1) a.) Value of Unlevered Company U = EBIT (1 - tax rate) / Cost of equity
= 4 * (1 - 0.40) / 0.10
= 2.4 / 0.10
= $ 24 Million
1) b.) Value of Company levered L = Value of Unlevered company (U) + Debt * Tax rate
= 24 + 20 * 0.40
= 24 + 8
= $ 32 Million
2) a) Cost of equity (rs) for firm U = 10 %
b) Cost of equity (rs) for firm L = EBIT - interest / Total value for firm L
= 4 Million - (20 Million * 5 %) / 32
= 4 Million - 1 Million / 32
= 3 /32 = 0.09375 i.e., 9.375 Or 9.38 % (approx)
3) a.) WACC for firm U (Unlevered) = 10 %
b.) WACC for firm L (Levered) = EBIT (1 - Tax rate ) / Total market value of company L * 100
= 4 Million * (1 - 0.40) / 32 Million * 100
= 2.4 / 32 * 100
= 7.5 % (approx)
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