1. Companies U and L are identical in every respect except that U is unlevered w
ID: 2711019 • Letter: 1
Question
1. Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 4.2% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) there are no corporate or personal taxes, (3) EBIT is $1.7 million, and (4) the cost of equity to Company U is 9.8%.
What is the required percentage rate of return of equity for Company L?
2. Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 4.4% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both companies are subject to a 33% federal-plus-state corporate tax, (3) EBIT is $2.1 million, and (4) the cost of equity to Company U is 10%. What is the value, in millions, of Company L under the MM model?
3.
Higgs Bassoon Corp. borrowed heavily and is reducing its debt over the next 3 years to a sustainable level. Higgs Bassoon has forecast free cash flows and the tax savings due to the deductibility of interest expense for the next three years, as shown below:
The FCF and tax savings are expected to grow at a constant rate of 5.2% after Year 3. The unlevered cost of equity is 11% and its tax rate is 34%. What is the horizon value of unlevered firm?
4. Fredrickson Corp. has $10 million of 5% bonds outstanding. Assume that all of the MM assumption are met, and the firm is subject to a 35% federal-plus-state corporate tax rate. The firm has an EBIT of $1 millions, and the unlevered cost of equity is 8.6%. What is the implied value of Fredrickson's equity, in millions?
1 2 3 Free cash flow $1,000 $1,200 $1,350 Tax savings $320 $240 $160
Explanation / Answer
ANSWER 1
RATE OF RETURN OF EQUITY OF LEVERD = RATE OF EQUITY OF UNLEVERED(RE) + ( RE (UNLEVERED - RATE OF DEBT)=
=> 9.8% + ( 9.8% - 4.2%)
RATE OF RETURN OF EQUITY OF LEVERD = 15.4%
ANSWER 2
EBIT = 2.1 MILLION
LESS INTEREST = 0.44 MILLION
PROFIT AFTER INTEREST => 1.66 MILLION
COST OF EQUITY 10%
VALUE OF EQUITY => 1.66/10% => 16.6
VALUE OF FIRM => 16.6 + 10 => $ 26.6 MILLION
ANSWER 3
HORIZON VALUE =$23483
ANSWER 4
VALUE OF UNLEVERED FIRM = $ 1 MILLION / 8.6% => 11.63
VALUE OF LEVERED FIRM
EBIT = 1
LESS INTEREST = 0.5
PROFIT => 0.5
VALUE OF EQUITY OF LEVERED FRIM => 0.5 / 8.6% => 5.81
TOTAL VALUE OF FREDRICKSONS'S EQUITY IS => $11.63 + $5.81 => $17.44 MILLION
YEAR FREE CASH FLOW TAXSAVING TOTAL OF BOTH DISCOUNTING FACTOR HORIZON VALUE 1 1000 320 1320 0.901 1189.32 2 1200 240 1440 0.812 1169.28 3 1350 160 1510 0.731 1103.81 3 CONSTANT GROWTH (1350+5.2%)/(11-5.2)%= 24486 160+5.2%)/(11-5.2)%= 2902 27388 0.731 20020.628 TOTAL 23483Related Questions
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