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?