Questions -
Q1. Assume that two firms, U and L, are identical in all respects except one: Firm U is debt free, whereas firm L has a capital structure that is 50% debt and 50% equity by market value. Further suppose that the assumptions of M&M's "irrelevance" Proposition I hold (no taxes or transactions cost, no bankruptcy cost, etc.) and that each firm will have earnings before interest and taxes (EBIT) of $800,000.
If required return on assets, r, for these firms is 12.5% and the risk free debt yields 5%, calculate the following values for both firm U and firm L. (1) total firm value, (2) market value of debt and equity, and (3) required return on equity.
Q2. SoonerCo has $15 million of common stock outstanding, earnings before interest and taxes (EBIT) of $2.5 million per year, and $15 million of debt outstanding with a required return (interest rate) of 8%. The required rate of return on assets in this industry is 12%, and the corporate tax rate is 35%. Within the M&M framework of corporate taxes but no personal taxes, determine the present value of the interest tax shield of SoonerCo as well as the firm's total value. Finally, determine the gain from leverage if there are personal tax rate of 15% on stock income and 25% on debt income.