Company A and Company B are identical in every respect except that Company A is unlevered while Company B has $100,000 of 10% bonds outstanding in perpetuity. Company A's cost of capital is 15% and Company B's cost of equity is 18%. EBIT for both companies is expected to remain at $25,000 forever. Assume all earnings are immediately paid out as dividends, investors are able to borrow at 10%, and all the M&M assumptions are satisfied.

 

1. What is the value of each firm? 

2. You own 10% of Company B's equity. Use the M&M arbitrage argument to show the process and amount by which you could increase your wealth without changing your future annual cash flows. 

3. Show your cash flow before and after your transactions in part 2. For all remaining questions, assume the cost of equity for Company B was not provided. 

4. What is the value of each firm? 

5. What is the cost of equity for each firm? 

6. What is the WACC for each firm? For all remaining questions, assume the companies are subject to a 40% corporate tax rate. 

7. What is the value of each firm? 

8. What is the cost of equity for each firm? 

9. What is the WACC for each firm? For all remaining questions, assume investors are subject to a 30% tax rate on debt income and 22% tax rate on equity income. 

10. What is the value of each firm? 

11. Compare the gains from leverage in parts 4, 7, and 10