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

$ Million A EBIT =               3.00 Tax Rate = 35% Firm U Unlevered cost of Equity =rs= 13% Value of unlevered firm=EBIT(1-T)/rs Value of U= 3*(1-0.35)/13%=             15.00 So Value of Firm U =$ 15 million Firm L Debt amount =$ 18 million Value of levered firm= Value of unlevered firm+Taxrate*Debt =15+35%*18 =                   21 million So value of L =$21 million B Value of rs in U =13% Value of L                   21 Value of debt in L=D                   18 C Value of equity in L=SL                     3 D/E ratio in L =18/3=6:1 rs in L = rs Unelevered+ [(1-T)*D/E*(rs-rd) rd=6% rsin L= 13%+0.65*6/1*(13%-6%) rs in L= 40.3% D WACC is U =13% WACC is L= E/(D+E)*rs+D/(D+E)*rd   =1/7*0.403+6/7*0.06*(1-0.35) 9.10%

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