Problem 21-7

MM with Corporate Taxes

Companies U and L are identical in every respect except that U is unlevered while L has $20 million of 5% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both firms are subject to a 40% federal-plus-state corporate tax rate, (3) EBIT is $4 million, and (4) the unlevered cost of equity is 10%.

1. What value would MM now estimate for each firm? (Hint: Use Proposition I.) Enter your answers in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answers to two decimal places.

   Company U	$ million
   Company L	$ million

2. 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.%
3. 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 $1.2 million should be entered as 1.2, not 1,200,000. Do not round intermediate calculations. Round your answers to two decimal places. S_L = $ million S_L + D = $ million
4. 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.%