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:

Skilled Nursing Facility

A healthcare setting offering high-level medical care and nursing services, typically for individuals recovering from illness or injury.

Lashes Out

A phrase describing a sudden expressive act of verbal or physical aggression.

Seclusion Order

An official directive to isolate an individual, typically for health, safety, or behavioral reasons.

Secluding the Patient

Secluding the patient involves isolating an individual, often in a healthcare setting, for the purpose of safety or to manage specific symptoms or behaviors.