Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corporation is an unlevered firm, and R Inc. is a levered firm with debt of $3.5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of $1.5 million and a marginal corporate tax rate of 35%. Q Corporation has a cost of capital of 15%.

a.What is Q Corporation's firm value?

b.What is R Inc.'s firm value?

c.What is R Inc.'s equity value?

d.What is Q Corporation's cost of equity capital?

e.What is R Inc.'s cost of equity capital?

f.What is Q Corporation's WACC?

g.What is R Inc.'s WACC?

h.Compare the WACC of the two companies. What is your conclusion?

i.What principle have you proven in this case?

j.Both companies are now evaluating a project that requires an initial investment of $1.15 million, that will yield after tax cash inflows of $500,000 per year for the next three years. Assume that this project has the same risk level as each individual firm's assets. Should Q Corporation invest in this project? Should R Inc. invest in this project?

k.Based on your results in part (j), discuss the effects of leverage and its tax shields on the future value of the two firms.