Question

Tool Manufacturing has an expected EBIT of $65,000 in perpetuity and a tax rate of 21 percent. The firm has $190,000 in outstanding debt at an interest rate of 4.3 percent, and its unlevered cost of capital is 10.2 percent. What is the value of the firm according to MM Proposition I with taxes?

Answer 1

Answer: $543,331.37

Explanation:

According to MM Proposition I with taxes, the value of a leveraged firm is equal to the value of the Unlevered firm (VU) plus the present value of the interest tax shield.

To calculate it, one uses the following formula,

VL =Vu+ Te * D

Where,

Te = the corporate tax rate

D = the amount of debt.

First then we would need to calculate Vu, the Unlevered value of the firm.

Listing the figures we have,

Expected EBIT of $65,000 forever Tax rate of 21%

Outstanding Debt is $190,000 Interest rate on debt is 4.3% Unlevered cost of capital is 10.2%

Solving for the value of the Unlevered firm we have,

Value of Unlevered firm (Vu) = EBIT (1-T) /RU

= $ 65000 ( 1-T) / RU

= $ 65000 (1- 0.21) /0.102

= $503,431.37

That is the Unlevered Value.

Now we can find the value of the levered firm as

VL =Vu+ Te *D

Value of levered firm,

= $503,431.37 + 0.21(190,000)

= $543,331.37

Therefore, the value of levered firm according to M&M Proposition I is $543,331.37.