Unlevered Corporation (Firm U) has a total market value of $5,000,000, a tax rate of 40 percent, and earnings before interest and taxes (EBIT) of $1,000,000. Levered Corporation (Firm L) is identical in all respects to Firm U, but Firm L has $3,000,000 market (and book) value of debt outstanding. Firm L pays total annual interest of $270,000 on this debt. Both firms satisfy the MM assumptions.
a. What is the value of Firm L according to MM’s Proposition I with corporate taxes?
b. What is Firm U’s cost of equity?
c. What is Firm L’s cost of equity?
d. What is Firm L’s weighted average cost of capital?