(21-3)

Compressed APV Model with Constant Growth

An unlevered firm has a value of $800 million. An otherwise identical but levered firm has $60 million in debt at a 5% interest rate, which is its pre-tax cost of debt. Its unlevered cost of equity is 11%. After Year 1, free cash flows and tax savings are expected to grow at a constant rate of 3%. Assuming the corporate tax rate is 25%, use the compressed adjusted present value model to determine the value of the levered firm. (Hint: The interest expense at Year 1 is based on the current level of debt.)

(21-7)

MM with Corporate Taxes

Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 5% bonds outstanding. Assume: (1) All of the MM assumptions are met. (2) Both firms are subject to a 25% federal-plus-state corporate tax rate. (3) EBIT is $2 million. (4) The unlevered cost of equity is 10%.

a.What value would MM now estimate for each firm? (Hint: Use Proposition I.)

b.What is rs for Firm U? For Firm L?

c.Find SL, and then show that SL + D = VL results in the same value as obtained in part a.

d.What is the WACC for Firm U? For Firm L?