Problem 21-7 MM with Corporate Taxes Companies U and L are identical in every re

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 $18 million of 5% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both firms are subject to a 35% federal-plus-state corporate tax rate, (3) EBIT is $2 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.

B. 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.
_____%

C. 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

D. 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

A) Value of U=2*(1-0.35)/0.10=$ 13.00 million

Value of L(According MM I)=VL=

=Value of U+Tax rate*Debt

=$ 13 million + $ 0.35*18 million

=$ 13 million+ $6.30 million

=$ 19.30 million

B) rs for Firm U=10.0%

Value of equity for firm L=$ 19.30 million-$ 18 million=$ 1.30 million

rs for Firm L=10%+(18/1.3)*(0.10-0.05)*0.65=55.0%

C)Value of Equity for L=SL=(2-0.05*18)*(1-0.35)/0.55=$ 1.30 million

D=$ 18 million

SL+D= $ 1.30 million + $ 18 million=$19.30 million=VL

D) WACC for Firm U=10.00%

WACC for Firm L: 19.30=2*(0.65)/Wacc =>Wacc =1.3/19.3=0.0674=6.74%

Also , Wacc=(1.3/19.3)*55%+(18/19.3)*5%*(1-0.35)=6.74%

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