Question

You own all of the equity in a debt-free app development business that generates cash flows of $570,000 each year in perpetuity. The cost of assets, kAssets is 12 percent and the tax rate is 20 percent. f you decide to replace $1 million of equity by borrowing $1 million at an interest rate of 5 percent how much would the value of the firm increase?

Answer #1

According to MM theory of capital structure with taxes, the value of unlevered firm will increase by the interest tax shield.

If the debt is only temporary for the current periods, then

**Value increase = Interest tax shield = Debt * Interest
rate * Tax rate = 1,000,000 * 5% * 20% = $ 10,000**

If debt is perpetual then ,

**Value increase = Value of interest tax shield till
perpetuity= Interest tax shield/ Interest rate = Debt * Tax
rate**

**= 1,000,000 * 20% = $ 200,000**

You own all of the equity in a debt-free app development
business that generates cash flows of $420,000 each year in
perpetuity. The cost of assets, kAssets is 10 percent
and the tax rate is 25 percent. What is the value of your
all-equity firm?
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