Question

The Bellwood Co. is financed entirely with equity. The company is considering a loan of $5.1 million. The loan will be repaid in equal principal installments over the next two years and has an interest rate of 9%. The company tax rate is 25%.

According to MM Proposition I with taxes, what would be the increase in the value of the company after the loan?

Answer 1

MM proportion I advocates that a firm can increase it's Value by Financing through debt. This is because the interest paid is tax deductible and it has tax shield.

So , Interest rate shield will be addition in the value of firm .

So interest paid on loan=( 5.1/2)= 2.55 Millions each installments

Interest on loan=[ 5.1×9%]+ [2.55×9%]

= .459+.2295

= .6885 Millions

Tax shield= (.6885 × Tax rate)

=(.6885×25%)

=$.172125 Millions or $172125

The firm value would be increased by $172125.