MM without Taxes (PLEASE NOTE THAT NUMBERS ARE DIFFERENT THATN IN TEXTBOOK) Comp
ID: 2760439 • Letter: M
Question
MM without Taxes (PLEASE NOTE THAT NUMBERS ARE DIFFERENT THATN IN TEXTBOOK)
Companies U and L are identical in every respect except that U is unlevered while L has $8 million of 7% bonds outstanding. Assume that (1) there are no corporate or personal taxes, (2) all of the other MM assumptions are met, (3) EBIT is $1 million, and (4) the cost of equity to Company U is 10%.
a. What value would MM estimate for each firm? 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 two decimal places.
________ %
What is rs for Firm L? Do not round intermediate calculations. Round your answer to two decimal places.
________ %
c. Find SL. Round your answer to two decimal places. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000.
$ ________ million
d. What is the WACC for Firm U? Round your answer to one decimal place.
________ %
What the WACC for Firm L? Round your answer to one decimal place.
________ %
e. Suppose VU = $20 million and VL = $22 million. According to MM, are these values consistent with equilibrium?
_________________
Explanation / Answer
a) Value of Unlevered firm = EBIT/rsu = 1,000,000/0.1 = $10,000,000
Value of levered firm = value of unlevered firm = $10,000,000
Under MM Theory (without taxes) the value of the unlevered firm = the value of the levered firm.
b) rs for firm U = 10.00%
rs for firm L = rsu + D/S(rsu - rd) = 10 + (8/2)(10-7) = 22%
c) SL = Value of the firm - Value of debt = 10,000,000 - 8,000,000 = $2,000,000
d) WACC for firm U = 10%
WACC for for firm L = 7*0.8 + 22*0.2 = 10%
Under MM Theory (without taxes) the WACC of unlevered firm and WACC of levered firm are equal.
e) The values are not consistent with equilibrium. Arbitrage will set it to make the values of the firms equal.
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