Consider Two Firms, U and L, Both with $50,000 in Assets

question 15

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.
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.

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Definitions:

Cost Function

A mathematical relationship that describes how production costs change with variations in output level.

Reaction Curves

Graphs showing how one firm’s optimal output decision responds to quantities of output by competing firms in a market.

Simultaneous Equations

A set of equations containing multiple variables that are all solved together.

Cross-License

An agreement between two or more parties to grant mutual rights to their respective intellectual property.