Skim Milk and Part Whole Milk are identical firms except that Skim is more lever

Question

Skim Milk and Part Whole Milk are identical firms except that Skim is more leveraged than Part Whole. The probability of a recession is equal to the probability of an expansion. If recession occurs, each Firm will have EBIT of $0.5 million next year. If expansion occurs, each firm will have EBIT of $3 million next year. Part Whole’s debt interest obligation requires $0.5 million in payments. Skim has more debt, its interest obligation is $1.5 million. Assume Skim’s WACC is 10%, Whole Milk’s debt holders require 3% rate of return, Skim’s debt holders require 5% in return. Assume one period and no taxes.

a) What’s the value of equity for each firm?

b) Use e, a, d of Part Whole or Skim to show MM proposition two (e =a+D/E *( a –d)). Assume market risk premium is 5%.

Explanation / Answer

Expected EBIT next year = $0.5 million * 0.5 + $3 million * 0.5

= $1.75 million

Thefore, Firm value = Expected EBIT / WACC

= $1.75 million / 10%

= $17.50 million

Value of debt for Skim = $1.5 million / 5%

= $30.00 million

Value of debt for Part Whole = $0.5 million / 3%

= $16.67 million

(a) Value of equity = Value of firm - Value of debt

Value of equity for Skim = $17.50 million - $30.00 million

= -$12.50 million

Value of equity for Part Whole = $17.50 million - $16.67 million

= $0.83 million

(b) Not sure

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