MM with Corporate Taxes (PLEASE NOTE THAT NUMBERS ARE DIFFERENT THAN IN TEXTBOOK

Question

MM with Corporate Taxes (PLEASE NOTE THAT NUMBERS ARE DIFFERENT THAN IN TEXTBOOK)

Companies U and L are identical in every respect except that U is unlevered while L has $18 million of 6% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both firms are subject to a 35% federal-plus-state corporate tax rate, (3) EBIT is $3 million, and (4) the unlevered cost of equity is 13%.

A. What value would MM now estimate for each firm? (Hint: Use Proposition I.) 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.

B. What is rs for Firm U? Round your answer to one decimal place.
________ %

What is rs for Firm L? Do not round intermediate calculations. Round your answer to one decimal place.
________ %

C. Find SL, and then show that SL + D = VL results in the same value as obtained in part a. Enter your answers in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Do not round intermediate calculations. Round your answers to two decimal places.
SL = $   ________ million
SL + D = $   ________ million

D. What is the WACC for Firm U? Do not round intermediate calculations. Round your answer to two decimal places.
________ %
What is the WACC for Firm L? Do not round intermediate calculations. Round your answer to two decimal places.
________ %

Explanation / Answer

Part A)

The value of the unlevered firm can be calculated as follows:

VU= EBIT*(1-Tax Rate)/Cost of Equity = 3000000*(1-35%)/(13%) = $15,000,000

The value of the unlevered firm can be calculated as follows:

VL = Value of Unlevered Firm + Tax Rate*Value of Debt = 15,000,000 + 35%*18,000,000 = $21,300,000

_________

Part B)

The Rs for Firm U will be same as the unlevered cost of equity of 13%.

_____

The Rs for Firm L is calculated as below:

Rs = (EBIT - Interest)*(1-Tax Rate)/(Value of Levered Firm - Value of Debt) = (3,000,000 - 18,000,000*6%)*(1-35%)/(21,300,000 - 18,000,000) = 37.8%

_________

Part C)

The SL is calculated as follows:

SL = Value of Levered Firm - Value of Debt = 21,300,000 - 18,000,000 = $3,300,000 or $3.3 million

SL + D = 3.3 + 18 = $21.3 million

_________

Part D)

The WACC for Firm U will be 13% which is same as cost of equity.

________

The WACC for Firm L is calculated as follows:

WACC = Cost of Debt*(1-Tax Rate)*(D/V) + Cost of Equity*(S/V) = 6%*(1-35%)*(18,000,000/21,300,000) + 37.8%*(3,300,000/21,300,000) = 9.15%

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