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

question 37

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. Assume MM with taxes.

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Definitions:

Total N

Total N refers to the total number of observations or samples in a study or experiment.

Chi-square Statistic

A statistic used to assess the fit of an observed distribution to an expected distribution.

Critical Value

Value of a statistic that separates the regions of rejection and nonrejection.

Degrees Of Freedom

An aspect of inferential statistical tests, representing the amount of unrestricted parameters in the data set.