Question

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. (4) The unlevered cost of equity is 10%. What value would MM now estimate for each firm? (Hint: Use Proposition I.) Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Round your answers to two decimal places.

Answer 1

Answer: $19.5 million

Explanation:

Given that,

U is unlevered

L = $18 million 6% bonds outstanding

Corporate tax rate = 35%

EBIT = $3 million

Unlevered cost of equity = 10%

$Value\ of\ Firm\ U, Vu = EBIT\times\frac{(1-Tax\ Rate)}{unlevered\ cost\ of\ equity}$

$Value\ of\ Firm\ U, Vu = 3\times\frac{(1-0.35)}{0.1}$

                                           = $3 × 6.5

                                           = $19.5 million