MM with Corporate Taxes Companies U and L are identical in every respect except
ID: 2782410 • Letter: M
Question
MM with Corporate Taxes Companies U and L are identical in every respect except that U is unlevered while L has $12 million of 8% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both firms are subject to a 40% federal-plus-state corporate tax rate, (3) EBIT is $5 million, and (4) the unlevered cost of equity is 12%. a. What value would MM now estimate for each firm? 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. (Hint: Use Proposition I.) Company U million million 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 S D V results in the same value as obtained in part a. Enter your answers in millions. For example, an answer of s1.2 million should be entered as 1.2, not 1,200,000. Do not round intermediate calculations. Round your answers to two decimal places. million 51 + 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 placesExplanation / Answer
a)
Value of U = EBIT*(1-tax rate) / cost of equity
VU = 5*(1-0.4) / 0.12 = 25
VL = VU + T*D
VL = 25 +0.4*12 = 29.8
b)
Equity value of L (SL)= total value - debt = 29.8 - 12 = 17.8
RsU = 12% (pure equity)
RsL = RsU + (RsU - Rd)*(1-Tax rate)*D/E
RsL = 0.12 + (0.12 - 0.08)*(1-0.4)*12/17.8 = 13.6 %
c)
Equity value of L = total value - debt = 29.8 - 12 = 17.8
SL + D = 17.8 + 12 = 29.8
d)
WACC for U = 12% (only equity)
WACC for L = (D/V)*(1-tax rate)*Rd + (SL/D)*RsL
WACC for L = (12/29.8)*(1-0.4)*0.08 + (17.8/29.8)*0.136 = 10.07%
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