Miller Model Companies U and L are identical in every respect except that U is u
ID: 2613707 • Letter: M
Question
Miller Model
Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 8% bonds outstanding. Both firms have an EBIT of $3 million. Assume that all of the MM assumptions are met.
Suppose that both firms are subject to a 35% federal-plus-state corporate tax rate, investors in both firms face a tax rate of Td = 28% on debt income and Ts = 20% (on average) on stock income, and the appropriate required pre-personal-tax rate rsU is 10%.What is the value of the unlevered firm, VU? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places.
1. Suppose that both firms are subject to a 35% federal-plus-state corporate tax rate, investors in both firms face a tax rate of Td = 28% on debt income and Ts = 20% (on average) on stock income, and the appropriate required pre-personal-tax rate rsU is 10%.
a. What is the value of the unlevered firm, VU?
b. What is the value of the levered firm, VL?
2. Keep the other assumptions (D = $10 million, rd = 8%, EBIT = $3 million, and rsU = 10%) but now suppose Td = Ts = 0 and Tc = 40%.
a. What is the value of the unlevered firm, VU?
b. What is the value of the levered firm, VL?
3. Keep the other assumptions (D = $10 million, rd = 8%, EBIT = $3 million, and rsU = 10%) but now suppose that Td = 28%, Ts = 28%, and Tc = 40%.
a. Now what is the value of the levered firm?
b. What is the gain from leverage?
Explanation / Answer
1. Suppose that both firms are subject to a 35% federal-plus-state corporate tax rate, investors in both firms face a tax rate of Td = 28% on debt income and Ts = 20% (on average) on stock income, and the appropriate required pre-personal-tax rate rsU is 10%. a. Value of the unlevered firm, VU = EBIT*(1-T)/r Earning before interest and tax (EBIT) $3,000,000 Tax Rate (T) 35% Rate (rSU) 10% Value of the unlevered firm Vu = $3,000,000 x (1-35%)/10% $19,500,000 b. Value of the levered firm VL = Vu+(1-(1-Tc)*(1-Ts)/(1-Td))*D Value of the unlevered firm Vu $19,500,000 Tax Rate (T) 35% Rate (rSU) 10% Tax rate on debt income Td 28% Tax rate on stock Ts 20% Debt $10,000,000 Value of the levered firm Vl = $19,500,000+(1-(1-35%)x(1-20%)x (1-28%))x10,000,000 Value of the levered firm Vl $22,277,778