Consider Two fiRms, U and L, Both with €50,000 in Assets.Firm

question 6

Essay

Consider two firms, U and L, both with €50,000 in assets.Firm U is unlevered, and firm L has €20,000 of debt that pays 8% interest.Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding.Mike owns 20% of firm L and believes that leverage works in his favor.Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.Given a level of operating income of €2,500, show the specific strategy that Mike has in mind.After seeing Steve's analysis, Mike tells Steve that while his analysis looks good on paper, Steve will never be able to borrow at 8%, but would have to pay a more realistic rate of 12%.Suppose the tax authorities allow firms to deduct their interest expense from operating income. Both firm U and firm L are in the 34% tax bracket.Show what happens to the market value of both firms if the debt held by firm L is permanent.Assume MM with taxes.

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Definitions:

GDP

Gross Domestic Product, the total value of all final goods and services produced within a country in a given period of time.

Tax Cuts

A reduction in the amount of taxes imposed by a government on individuals or businesses.

Monetary Policy

The process by which a central bank, currency board, or monetary authority controls the supply of money, or trading in foreign exchange markets.

Fiscal Policy

Government policy regarding taxation and spending to influence the economy.