Levered, Inc., and Unlevered, Inc., are identical in every way except their capi

Question

Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $28 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual debt has a market value of $81 million and costs 7 percent per year. Levered has 1.3 million shares outstanding, currently worth $125 per share. Unlevered has no debt and 3.5 million shares outstanding, currently worth $69 per share. Neither firm pays taxes.

Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $28 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual debt has a market value of $81 million and costs 7 percent per year. Levered has 1.3 million shares outstanding, currently worth $125 per share. Unlevered has no debt and 3.5 million shares outstanding, currently worth $69 per share. Neither firm pays taxes.

Explanation / Answer

Value of unlevered(assets is equal to equity)=3.5*69 million=241.5 million

return on assets=28/241.5=11.5942%

total value of levered=value of unlevered=241.5 million

Debt of levered=81 million
Hence, equity of levered=241.5-81=160.5 million

But we see that Market value of Equity of levered=1.3*125=162.5 million So equity is overvalued

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