Firm U is an all equity firm and has a market value of $500,000 and EBIT of $100,000. Firm L is identical in all respects to Firm U, but Firm L has $200,000 market value of debt outstanding and $400,000 worth of stock. Firm L pays total annual interest of $16,000 on his debt and has a tax rate of 40 percent. Both firms satisfy the MM assumptions.
a. What is the value of firm L according to MM's proposition 1 with corporate taxes?
b. Micky is the holder of $30,000 worth of L's stock. What rate of return can he expect, assuming a dividend payout of 100%.
c. Using homemade leverage, show how Micky could generate exactly the same cashflows and rate of return by investing in Firm U.