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