Question
You are analyzing the capital structure of two companies: Company U and Company L. Both companies have the same perpetual EBIT of $30 million but
You are analyzing the capital structure of two companies: Company U and Company L. Both companies have the same perpetual EBIT of $30 million but different capital structure. Company U is entirely financed with equity, while Company L has $60 million 8% bonds outstanding. The corporate tax rate is 32%. The personal tax rate for all investors is 28% on interest income and 20% on equity income. The cost of equity for Company U is 12%.
(a) What is the value of Company U? (b) What is the value of Company L? (c) Is there a gain from leverage from the use of debt for Company L? If so, how large is the gain? (d) The government just proposed tax reform. The new tax rate becomes a flat rate of 30% for all corporate and individual income. What is the value of each company?
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