1. Tool manufacturing has an expected EBIT of $23,000 in perpetuity and a tax rate of 35%.
The firm has $65,000 in outstanding debt at an interest rate of 8%, and its unlevered cost
of capital is 13%. What is the value of the firm according to MM proposition I with
taxes? Should Tool change its debt-equity ratio if the goal is to maximize the value of the
firm? Explain.
2. Able Company and Baker Company are identical in market value of assets. The two company
have different capital structures. Able company, an all-equity firm, has 7000 shares of stock
outstanding, currently worth $23 per share. Baker Company uses leverage in its capital structure.
The market value of Baker’s debt is $38,000, and its cost of debt is 9%. Each firm is expected to
have earnings before interest of $32,000 in perpetuity. Neither firm pays taxes. Assume that
every investor can borrow at 9% per year.
a. What is the value of Able Company
b. What is the market value of Baker Company’s equity
c. How much will it cost to purchase 30% of each firm’s equity?
d. Assuming each firm meets its earnings estimates, what will be the dollar return to
each position in part (d) over the next year?
e. Construct an investment strategy in which an investor purchases 30% of Able’s
equity and replicates both the cost and dollar return of purchasing 30% of Baker’s
equity.

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