MM without Taxes Companies U and L are identical in every respect except that U

Question

MM without Taxes

Companies U and L are identical in every respect except that U is unlevered while L has $9 million of 6% bonds outstanding. Assume that (1) there are no corporate or personal taxes, (2) all of the other MM assumptions are met, (3) EBIT is $3 million, and (4) the cost of equity to Company U is 10%.

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.

a. What is rs for Firm U? Round your answer to two decimal places.
_______%

b. 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

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.
________%

Explanation / Answer

1) Value of unlevered firm = EBIT / Cost of equity = 3 / 10% = $30 million

Without taxes, Value of levered firm = Value of unlevered firm = $30 million

a) rs for Firm U = 10%

b) For Firm L, rs = rsu + (rsu - rd) x D / E = 10% + (10% - 6%) x 9 / 21 = 11.71%

c) SL = Equity Value of levered firm = (EBIT - Interest) / rs = (3 - 9 x 6%) / 11.71% = $21.00

d) WACC for both firms U and L = 10%

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