Question

Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $12.6 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual debt has a market value of $74 million and costs 5 percent per year. Levered has 3.2 million shares outstanding that sell for $90 per share. Unlevered has no debt and 4.9 million shares outstanding, currently worth $73 per share. Neither firm pays taxes. What is the value of each company's equity?

Answer 1

Answer: Unlevered firm Equity is worth $357,700,000.

Levered firm Equity is worth $283,700,000 going by the Modigliani-Miller Proposition I.

Explanation:

The Unlevered firm has no debt and so the value of it's equity can be calculated by simply multiplying shares outstanding by the market price.

= 4.9 million * 73

= $357,700,000

Unlevered firm Equity is worth $357,700,000.

Now according to Modigliani-Miller Proposition I, if a Levered firm and an identical Unlevered firm are not paying taxes, they should be of equal value.

This means that the Levered firm should have a value of $357,700,000 meaning that their equity should be that value minus the value of their debt.

= 357,700,000 - 74,000,000

= $283,700,000

$283,700,000 should be the value of their Equity going by the Modigliani-Miller Proposition I.

Calculating with their figures however gives,

= 3.2 million * 90

= $288,000,000

The market value of the Levered firm is more than it's value according to the Modigliani-Miller Proposition I.

This means that the Unlevered firm's Equity is UNDERVALUED and the Levered Firm's Equity is OVERVALUED.