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In: Economics

Firm B has an expected EBIT of £40,000 in perpetuity and a tax rate of 28 per cent. The firm has £50,000 in outstanding debt at an interest rate of 6 per cent, and its unlevered cost of capital is 12 per cent.

Firm B has an expected EBIT of £40,000 in perpetuity and a tax rate of 28 per cent. The firm has £50,000 in outstanding debt at an interest rate of 6 per cent, and its unlevered cost of capital is 12 per cent.
Required:
(i) What is the value of the firm according to Modigliani and Miller (M&M) Proposition I with taxes?
(ii) Should firm B change its debt–equity ratio if the goal is to maximize the value of the firm? Explain.

Solutions

Expert Solution

i)

Value of levered firm = EBIT*(1-Tax)/Cost of capital + Tax rate*Debt

                                       = 40000*(1-28%)/12%+28%*50000

                                       = 240000+ 14000

                                       = 254000

 

ii)

Yes the company should take on more debt. As per the M&M proposition with taxes, higher the level of debt, higher will be the value of the company. This is due to tax advantages received on payment of interest on debt.

i. Value of levered firm = 254000

 

 

Junaid answered 2 years ago
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