Unlevered has 45 million shares of common stock outstanding worth 80 per share

# Unlevered has 45 million shares of common stock

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Unlevered has 4.5 million shares of common stock outstanding, worth \$80 per share. Therefore, the value of Unlevered: V U = 4,500,000(\$80) = \$360,000,000 Modigliani-Miller Proposition I states that, in the absence of taxes, the value of a levered firm equals the value of an otherwise identical unlevered firm. Since Levered is identical to Unlevered in every way except its capital structure and neither firm pays taxes, the value of the two firms should be equal. Therefore, the market value of Levered, Inc., should be \$360 million also. Since Levered has 2.3 million outstanding shares, worth \$105 per share, the market value of Levered’s equity is: S L = 2,300,000(\$105) = \$241,500,000 The market value of Levered’s debt is \$91 million. The value of a levered firm equals the market value of its debt plus the market value of its equity. Therefore, the current market value of Levered is: V L = B + S V L = \$91,000,000 + 241,500,000 V L = \$332,500,000 The market value of Levered’s equity needs to be \$360 million, \$27.5 million higher than its current market value of \$332.5 million, for MM Proposition I to hold. Since Levered’s market value is less than Unlevered’s market value, Levered is relatively underpriced and an investor should buy shares of the firm’s stock. Intermediate 17. To find the value of the levered firm, we first need to find the value of an unlevered firm. So, the value of the unlevered firm is: V U = EBIT(1 t C )/ R 0 V U = (\$57,000)(1 .35)/.15 V U = \$247,000 Now we can find the value of the levered firm as: V L = V U + t C B V L = \$247,000 + .35(\$90,000) V L = \$278,500 Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should continue to increase its debt/equity ratio to maximize the value of the firm.