Lambda Ltd has $100 million of perpetual debt outstanding with an interest cost of 9%. The...

Lambda Ltd has $100 million of perpetual debt outstanding with an interest cost of 9%. The company is currently subject to a corporate tax rate of 30%. Following national elections, the incoming government unexpectedly passes a law that lowers the corporate tax rate for all companies to 25%. According to Modigliani and Miller what will be the most likely immediate change in the market value of the company?

Expert Solution

According to Modigliani-Miller Proposition with taxes, the value of the firm is maximized at 100% debt. The reason for increase in value of the firm is due to tax shield. Interest payments are tax deductible. The tax liability reduces because of this debt related interest payments. The increase in the valie of the firm is tax rate times the debt amount.

Each year e tax savings is (tax rate)*(interest on debt)*(debt amount) . For perpetual cash increase, the present value comes out as (tax rate)*(interest rate on debt)*(debt amount)/(interest rate on debt) = tax rate * debt amount.

Now, as the tax rate is reduced, so will the value lf tax shield. The benefit will be lowered and the value of the company would fall immediately.

There should be a market value fall of (new tax rate - old tax rate)*(debt amount) = 0.05*100 million = $5million.

Thus, there should be a decrease in the value of firm by $5million.

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jeff jeffy answered 1 year ago

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