High School

If firm U is unlevered and firm L is levered, then which of the following is true?

I) \( V_U = E_U \)
II) \( V_L = E_L + D_L \)
III) \( V_L = E_U + D_L \)

Multiple Choice:
A. I, II, and III
B. III only
C. I and II only

Answer :

If firm U is unlevered and firm Lis levered, then I)VU = EU III) VL = EU + DL are true.

Explanation:
I) VU = EU

In an unlevered firm (firm U), the value of the firm (VU) is equal to the value of the equity (EU) since there is no debt. So, this statement is true.

II) VL = EL + DL
This statement suggests that the value of the levered firm (firm L) is equal to the value of the equity (EL) plus the value of the debt (DL). However, this may not always be true due to the presence of taxes and bankruptcy costs, which can affect the value of the levered firm. Therefore, this statement is not always true.


III) VL = EU + DL
In a levered firm (firm L), the value of the firm (VL) can be seen as the sum of the unlevered equity (EU) and the value of the debt (DL). This statement is true, assuming that there are no taxes or bankruptcy costs affecting the value of the levered firm.

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