An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of $150,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $700,000 with a 7% annual coupon. The applicable tax rate is 35%. What is the value of the levered firm?
Choose one answer.
Value of levered firm = Value of unlevered firm + Tax shield due to ...
The solution explains how to calculate the value of the levered firm
Firm value, levered and unlevered company
Firms U and L are identical in every respect except that U is unlevered (no debt) while L has $10 million of 5% bonds outstanding. Assume (1) that all of the MM assumptions are met, (2) that there are no corporate or personal taxes, (3) that EBIT is $2 million, and (4) that the cost of equity to Firm U is 10%. Please show all work.
a. What value would MM estimate for each firm?
b. What is rs for Firm U? For Firm L?
c. Find SL, and then show that SL + D = VL = $20 million
d. What is the WACC for Firm U? For Firm L?
e. Suppose VU = $20 million and VL =$22 million. According to MM, do these
values represent an equilibrium? If not, explain the process by which
equilibrium would be restored.