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a) Referring to Table bellow, find out the market value of firm L (firm a corporate income tax) if the equity amount in its capital structure decreases to $3000 and the debt amount increases to $3000.

b) For firm L (with equity = $3000 and equity and debt = $3000), find out (i) the income available to the stockholders and (ii) the cost of equity.

Table Capital Structure with a Corporate Income Tax:
Financial Data on Firms U and L
Firm U Firm L
Net Operating income (EBIT) $1000 $1000
Less: Interest payments to debt holders, I - 100
Income before taxes $1000 $900
Less: Corporate taxes (T=40%) 400 $360
Income available to stockholder(dividends), D $600 $540
Total income available to security holders (I+D) $600 $640
Required rate of return on debt, Kd - 5%
Market value of debt, (B=I/Kd) - $2000
Required rate of return on equity, Ke 10% 11.25%
Market Value of equity, (E=D/Ke) $6000 $4800
Market Value of Firm, (E+B) $6000 $6800

 

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