Question

Companies U and L are identical in every respect except that U is unlevered while L has $10 million of bonds with 5% interest rate. Assume that all of the MM assumptions are met, both firms are subject to a 40% corporate tax rate, EBIT is $2 million, and the unlevered firms cost of equity is 10%.

What is the value of the unlevered firm?
A) $10 million
B) $12 million
C) $16 million
D) $20 million

Answer 1

The value of the unlevered firm U with an EBIT of $2 million and a corporate tax rate of 40%, given that its cost of equity is 10%, is calculated to be $12 million.

Step-by-step explanation:

To calculate the value of the unlevered firm using the Modigliani-Miller Theorem under corporate taxes, we can start by computing the firm's earnings after taxes (EBT), which is the earnings before interest and taxes (EBIT) less interest on debt. In this case, company U is unlevered, so it has no debt and no interest expense. Therefore, the EBT is equal to the EBIT. For an unlevered company like U, with an EBIT of $2 million and a corporate tax rate of 40%, the after-tax earnings are $2 million * (1 - 0.4) = $1.2 million.

The value of an unlevered firm (Vu) is then calculated using the after-tax earnings and the cost of equity. Given a cost of equity of 10%, the value of the unlevered firm U can be calculated via the following formula:

Value of unlevered firm (Vu) = After-tax earnings / Cost of equity

Therefore, Vu = $1.2 million / 0.10 = $12 million.