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.

Mr. Toriop owns 5000 shares of stock in Yummy Corporation. The company has announced that it will pay a dividend of $5 per share in one year and then a liquidating dividend of $50 per share in two years. The required return on ABC stock is 10%.

a.What is the current share price of your stock?

c.Mr. Toriop wishes to have equal amount of dividend income for the next two years. How can he use homemade leverage on Yummy Corporation's dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage. (Hint: Dividends will be in the form of an annuity.)

d.Suppose Mr. Toriop is thinking about buying a house for $220,000 in one year. How can he use homemade leverage on Yummy Corporation's dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage.

e.Suppose Mr. Toriop is thinking about postponing the house purchase for two years, by which time the price of the house will have increased by $35,000. How can he use homemade leverage on Yummy Corporation's dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage.