Question

Companies U and L are identical in every respect except that U is unlevered and L has a debt of $10 million with the cost of debt rd being 5%. Assume that (1) all the MM assumptions are met, (2) all the firms are subject to a 40% tax rate, (3) EBIT is $2 million and (4) the unlevered cost of equity rsu is 10%. Based on MM model with corporate tax, what is the equity of the levered firm, i.e. what is SL

Answer 1

The equity of the levered firm is $6 million.

Step-by-step explanation:

Firm U value = Value of unlevered firm = (EBIT * (100% - Tax rate )) / Unlevered cost of equity = (2 * (100% - 40%)) / 10% = $12 million

Firm L value = Value of levered firm = Value of unlevered firm + (Debt * Tax rate) = 12 + (10 * 40%) = $16 million

This implies that:

SL = Equity of the levered firm = Value of levered firm - Debt = $16 - $10 = $6 million

Therefore, the equity of the levered firm is $6 million.