MM with Corporate Taxes

Companies U and L are identical in every respect except that U is unlevered while L has $18 million of 6% bonds outstanding. Assume that: (1) All of the MM assumptions are met. (2) Both firms are subject to a 35% federal-plus-state corporate tax rate. (3) EBIT is $3 million. (4) The unlevered cost of equity is 12%

a-What value would MM now estimate for each firm? (Hint: Use Proposition I.) Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Round your answers to two decimal places. Company U: $ ______million Company L: $ _______million

b_What is r_s for Firm U? Round your answer to one decimal place. ________ % What is r_s for Firm L? Do not round intermediate calculations. Round your answer to one decimal place. ________ %

c-Find S_L, and then show that S_L + D = V_L results in the same value as obtained in Part a. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answers to two decimal places. S_L = $ ______ million S_L + D = $ _____ million

d- What is the WACC for Firm U? Do not round intermediate calculations. Round your answer to two decimal places. _______%

What is the WACC for Firm L? Do not round intermediate calculations. Round your answer to two decimal places. _______%

Proposition I The value of a levered firm is equal to the value of an unlevered firm in the same risk class (Vu) plus the value of the tax shield (VTaxshiled) due to the tax deductibility of interest expenses. The value of the tax shield, which is often called the gain from leverage, is the present value of the annual tax savings. The annual tax saving is equal to the interest payment multiplied by the tax rate, T : Annual tax saving =rdD(T) Modigliani and Miller assume a no-growth firm, so the present value of the annual tax saving is the present value of a perpetuity. They assume that the appropriate discount rate for the tax shield is the interest rate on debt, so the value of the tax shield is VTaxshleld=rdrdD(T)=TD Therefore, the value of a levered firm is VL=VU+VTaxshleld=VU+TD