1. Unsaved The Latson Company (LC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. LC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity would rise to 9.5%. If this plan were carried out, what would be LC's new WACC and total value?
a) 7.38%; $800,008
b) 7.50%; $813,008
c) 7.50%; $790,008
d) 7.80%; $790,008
2. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
a) True
b) False
3. Babisham Company (BC), a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. BC uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. What is the value of the firm with corporate taxes according to the MM model?
a) $475,875
b) $528,750
c) $587,500
d) $646,250