Assume that firms U and L are in the same risk class, and that both have EBIT = $500,000. Firm U uses no debt financing, and its cost of equity is rsU = 14%. Firm L has $1 million of debt outstanding at a cost of rd = 8%. There are no taxes. Assume that the MM assumptions hold.
value of firm(v): Firm U = $3,571,429 // Firm L = $3,571,428
value of equity(s): Firm U = $3,571,429 // Firm L = $2,571,429
levered cost of equity(rsl) = 16.33%
WACC = 14%
1. Suppose that Firms U and L are growing at a constant rate of 7% and that the investment in net operating assets required to support this growth is 10% of EBIT.
a. Use the compressed adjusted present value (APV) model to estimate the value of U and L.
b. Also estimate the levered cost of equity and the weighted average cost of capital.