Question

Mill Co. is all equity financed and has value of $600 billion.

Otherwise identical but levered firm with 30% debt at 6% interest rate. No growth is expected.

Please using mm with corporate tax model to determine the value of a levered firm assuming tax rate of 25.

1) $700 billion

2)$600 billion

3) $645 billion

4) $852 billion

5) Not enough information

Answer 1

3) $645 billion

The value of levered firm = the valued of unlevered firm + PV of interest tax shield

the valued of unlevered firm = $600 billion

Total debt = 30% of $600 billion = $180 billion

Interest rate per year = 6%*$180 billion = $10.8 billion

Interest rate tax shield per year = 0.25*$10.8 billion = $2.7 billion

This shield is for every year till perpetuity

PV of interest tax shield = $2.7 billion /0.06 = $45 billion

Hence, The value of levered firm =  $600 billion + $45 billion = $645 billion