Question

If the correct value of the firm (in a M-M world without taxes and other frictions)...

If the correct value of the firm (in a M-M world without taxes and other frictions) is $800, and a corporate tax of 20% is imposed, what is the new value of the levered and unlevered firms (the levered firm will now have $400 of debt)? What is the value of equity in the levered firm?

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Answer #1

When taxes are absent

Value of unlevered firm = Value of levered firm = 800

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Now if taxes are imposed and tax rate = 20%

Value of unlevered firm = 800*(1-t) = 800*(1-0.20) = 640

Value of Levered firm = Value of unlevered firm + Debt * t

Value of Levered firm = 640 + 400*0.20 = 720

Value of equity in levered firm = Value of levered firm - debt = 720 - 400 = 320

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ANSWERS : Value of unlevered firm = 640, Value of levered firm = 720, value of equity in levered firm = 320

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