You are given the following information: EBIT (for firms L and U in perpetuity)

Question

You are given the following information: EBIT (for firms L and U in perpetuity) = $300,000; corporate tax rate (T) = 30%; cost of equity for firm U (Ksu or rsu) = 10%; cost of debt for firm L (Kd or rd) = 8%; level of debt for firm L (D) = $1,200,000.

What are the values of firm L (VL) and firm U (Vu), respectively, using the M&M theory with corporate taxes (T= 30)?

$2,460,000 (L), $1,200, 000 (U)

$2,100,000 (L), $2,100, 000 (U)

$2,460,000 (L), $2,460, 000 (U)

$2,460,000 (L), $2,100, 000 (U)

$2,460,000 (L), $1,200, 000 (U)

$2,100,000 (L), $2,100, 000 (U)

$2,460,000 (L), $2,460, 000 (U)

$2,460,000 (L), $2,100, 000 (U)

Explanation / Answer

Value of Firms L & U using M&M theory

Value of Firm U(Vu)

Cost of Equity (Ksu)=10%

EBIT = $300000

Tax = 30%

Vu =300000*(1-0.30) / 0.10 =$2100000

Value of Firm L(VL)

EBIT = $300000

Tax = 30%

Cost of Debt (Kd) =8%

Amount of Debt = $1200000

VL =Vu +Tax rate * Value of Debt

=2100000+1200000*30% =2460000

Option 4 Is correct answer.

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