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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.

Solution Preview

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?

VU = EBIT/ rSU = $2 million/0.10 = $20 million
VU = VL = $20 million ...

Solution Summary

This solution is comprised of a detailed explanation to answer what value would MM estimate for each firm, what is rs for Firm U? For Firm L, find SL, and then show that SL + D = VL = $20 million, what is the WACC for Firm U and For Firm L, suppose VU = $20 million and VL =$22 million, then, according to MM, answer whether these values represent an equilibrium. If not, explain the process by which equilibrium would be restored.

$2.19