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:

Population Correlation

A statistical measure that describes the strength and direction of a relationship between two variables across the entire population.

True Population

The true population refers to the entire group of individuals or instances that meet a set of criteria and from which a sample is drawn for research or statistical analysis.

Nominal Level

The simplest form of measurement scale that categorizes data without implying any order among the categories.

Chi-Square Test

A statistical test used to examine the association between categorical variables, assessing how likely observed frequencies are due to chance.