Firm U is an unlevered firm with $2.5 million of EBIT, tax rate 34%, and a 10% r

Question

Firm U is an unlevered firm with $2.5 million of EBIT, tax rate 34%, and a 10% required return on equity.

a. In the Modigliani-Miller framework, what is the market value of the unlevered firm U?

b. Suppose firm U is levered with $12 million of 7% bonds. What is the market value of the resulting levered firm L?

c. Suppose there are two firms, A and B, that are identical in all respects to the unlevered firm U and the levered firm L. The market value of A is $12,000,000 and the market value of B is $22,000,000. What is likely to happen as a consequence of these prices?

Explanation / Answer

Vl = Vu + Cost of debt But we know that After-tax cost of debt = Cost of debt (1-tax-rate)
Give that cost of debt is 7% on $12 million bonds
Therefore, after-tax cost of debt = 0.07 ( 1-0.34)
= 0.0462 or 4.62% value of a levered firm = $25,000,000 + $554,400 = $25,554,400
c) The market value of the levered firm is $12,000,000 and the market value of the unlevered firm is $22,000,000. As we know that lower tax burden comes with higher debt, the levered firm can benefit with the tax shield.But adding more and more dent to the capital structure will take the firm to a bankruptcy state if the firm is unable to pay the interest on debt.This is the reason why most of the healthy firms does not include 100% debt in their capital structure.Though the value increases with increased debt, investors does not prefer to invest as they will expect their income in the form of dividends.
Therefore, it is beneficial to add some amount of debt in the capital structure if the operating income is more than the interest expense.But adding 100% debt is not good to firms.

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