Question

MM Model with Corporate Taxes

An unlevered firm has a value of $700 million. An otherwise identical but levered firm has $140 million in debt at a 4% interest rate. Its cost of debt is 4% and its unlevered cost of equity is 11%. No growth is expected. Assuming the corporate tax rate is 35%, use the MM model with corporate taxes to determine the value of the levered firm. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000.

$   million

Answer 1

MM Model with corporate taxes states that if debt is added in the capital structure then there will be interest expense which will lead to interest tax shield which in return will decrease the taxes and will increase the foirm value

Value of the levered firm = Value of the unlevered + PV of the interest tax shield calculated at cost of debt

Here it is given that value of the unlevered firm is $700 M and the firm is identical to the other levered firm.

Value of unlevered firm = 700

Interest = 140*4% = $5.6 M

Interest Tax shield = 5.6 * 35% = 1.96

Cost of debt = 4%

PV of interest tax shield = interest tax shield / cost of debt

= 1.96 / 0.04

= $49 million

Value of levered firm = 700 + 49

= $749 Million