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# Capital Structure- Levered and Unlevered

The CEO of a company is worried about his company's level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other companies in the same industry average about 30% debt, while the CEO wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:

Assume that firms U and L are in the same risk class, and that both have EBIT = \$500,000. Firm U uses no debt financing and its cost of equity is Rsu = 14%. Firm L has \$1 million of debt outstanding at a cost of Rd = 8%. There are no taxes. Assume that the MM assumptions hold, and then: (2 QUESTIONS)

1) Graph (a) the relationships between capital costs and leverage as measured by D/V, and (b) the relationship between value and D.

2) Using the data given in part b, but now assuming that Firms L and U are both subject to a 40% corporate tax rate, repeat the analysis called for in b-(1) and b-(2) under the MM with-tax model.

#### Solution Preview

The CEO of a company is worried about his company's level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other companies in the same industry average about 30% debt, while the CEO wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:

We will calculate the value of the unlevered firm and levered firm for two case: i) no taxes and ii) taxes
The value of the levered firm = value of unlevered firm for no taxes
and
The value of the levered firm = value of unlevered firm + Tax shield when there are taxes

We will calculate the cost of equity for levered firm = r SL for both the cases
We then calculate the weighted average cost of capital for levered firm = r 0 for both the cases

For the unlevered firm the weighted average cost of capital r 0 = r SU as there is no debt

Assume that firms U and L are in the same risk class, and that both have EBIT = \$500,000. Firm U uses no debt financing and its cost of equity is Rsu = 14%. Firm L has \$1 million of debt outstanding at a cost of Rd = 8%. There are no taxes. Assume that the MM assumptions hold, and then: (2 QUESTIONS)

When there are no corporate taxes, value of levered firm VL = value of unlevered firm VU

required return on unlevered ...

#### Solution Summary

Uses Miller and Modigliani model to answer questions on capital structure.

\$2.19