Comparable Inc. generates a random earnings stream (before interest and taxes) that starts next year (year 1) at $100 million and is expected to grow each year at 2% for the indefinite future. The firm has a target 20% debt-to-value ratio and an equity beta of 1.5. The risk free interest rate is 5%, the risk premium is 8%, and the corporate tax rate is 20%.

LBO Inc. has the same business risk (in the same industry) and the same EBIT stream as Comparable. Currently, LBO has no debt. LBO will call a press conference this afternoon to announce a major restructuring plan to borrow 90% of the value of the existing unlevered firm at the prevailing interest rate. Assume that this debt is risk free. Under the restructuring plan, the firm will take a 5 year loan with five equal end-of-year installments. At the end of year 3, LBO is planning to pre pay the outstanding balance of the loan, and sell the company to a buyer with the same capital structure as Comparable. Note that, because all debt is risk free in this problem, it is correct to use a debt beta of zero when levering/unlevering.

(a) What is the market value of Comparable Inc.? Use WACC for your calculations.

(b) What is the market value of LBO Inc. after announcing its restructuring plan? Hint: Use APV for years 1 to 3. For years 4 and beyond, use WACC to compute the sale price of LBO (terminal value) at the end of year 3 before appropriately discounting this value back to time 0. For simplicity, you can use the all-equity firm's discount rate to discount the terminal value back to year 0.