Baker Corp. and Tucci Co. are identical in every respect except that Baker is un
ID: 2719258 • Letter: B
Question
Baker Corp. and Tucci Co. are identical in every respect except that Baker is unlevered and Tucci has $3.8 million of 5% bonds outstanding. Assume all of the following:
1) All of Modigliani and Miller's assumptions are met.
2) Both firms are subject to a 34% corporate tax rate.
3) EBIT is $2.0 million for both firms.
4) Investors in both firms face a tax rate (Td) of 34% on debt income and tax rate (Ts) of 8% on stock income.
5) The rate of return before personal taxes (rsU) is 14%.
Use Miller's model to fill in the table for Baker Corp. and Tucci Co.
Baker Co Tucci Co. Value of Firm Value of Stock Cost of Equity WACCExplanation / Answer
Answer:
As per Modigliani and Miller's Approach Capital Structure Theories with Tax Rate
Value of Levered Firm = Value of Unlevered Firm + Tax Rate x Debt
Here, both Baker Corp. and Tucci Co. are identical in every respect except that Baker is unlevered..
It means Value of Tucci Co. (Levered Firm) = Value of Unlevered Firm (Baker Corp) + Tax Rate x Debt
Calculation of Value of Unlevered Firm (Baker Corp)
Since Baker Corp has no debt all the required return belongs to Equity Shareholders.
Expected Rate of Return of Equity Shareholders after tax = 14% (1 - 0.34) = 9.24%
SO, the Value of Equity Capital = Earnings Available to Equity Sharholders / Expected Return = $1,320,000 / 9.24% = $14,285,714
So the Value of Tucci Co (Levered Firm) = Value of Unlevered Firm + Debt x Tax Rate = $14,285,714 + $3,800,000 x 34% = $14,285,714 + $1,292,000 = $15,577,714
If above calculation is right....than easily you can calculate rest of the things...Once you confirm the answer is correct i will calculate rest of the part of question...
EBIT $2,000,000 Less: Interest $0 EBT $2,000,000 Less: Tax ($680,000) Earnings After Tax $1,320,000Related Questions
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