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The current value of an unlevered firm is $18,000,000. The firm is considering borrowing $12,000,000 and...

The current value of an unlevered firm is $18,000,000. The firm is considering borrowing $12,000,000 and using the proceeds to repurchase shares. The firm can borrow at 7%. Assume all the Modigliani and Miller (M&M) assumptions are satisfied except the firm's corporate tax rate is 30%. According to M&M Proposition I with taxes, what would be the value of the firm after the capital restructuring?

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Answer #1

Value of unlevered firm = 18000000

Debt issued to repurchase shares = 12000000

tax rate = 30%

As per M&M preposition, if there is change in capital structure and debt is issued to repurchase shares, then value of firm will increase by present value of interest tax shield on debt.

Formula for value of levered firm after restructuring = value of unlevered firm + PV of interest tax shield

PV of interest tax shield = debt issued for repurchase *tax rate

=12000000*30%

=3600000

Value of levered firm after restsructuring =18000000+3600000

=21600000

So  value of the firm after the capital restructuring would be $21600000

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