Question

Three Piggies Enterprises has no debt. Its current total value is $74.4 million. Assume debt proceeds are used to repurchase equity.

Ignoring taxes, what will the company’s value be if it sells $34.2 million in debt? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Round your answer to the nearest whole number, e.g., 32.)

Value of the firm $

Suppose now that the company’s tax rate is 34 percent. What will its overall value be if it sells $34.2 million in debt? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Round your answer to the nearest whole number, e.g., 32.)

Value of firm $

Answer 1

Solution:-

a) As per M&M Proposition I with no taxes, the value of levered firm(V_L) is equal to the value of the unlevered firm(V_U). So, with no taxes , the value of firm if it issue debt is =

         V_U=V_L=$74,400,000

Hence the value of the firm = $74,400,000

b) As per M&M Proposition I with taxes, the value of levered firm can be calculated as follows.

V_L=V_U+Tax rate*Debt

V_L=Value of levered firm

V_U= Value of unlevered firm = $74,400,000

Tax rate= 34%

Debt = $34,200,000

Note1:-" Tax rate*Debt " in above formula simply represent the present value of tax shield or PV of tax saving on interest cost.

Substituting the values we get,

V_L=$74,400,000 +0.34*$34,200,000 =$86,028,000

Hence the value of firm = $86,028,000

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