Question

The Bellwood Company is financed entirely with equity. The company is considering a loan of $3.4 million. The loan will be repaid in equal principal installments over the next two years and has an interest rate of 8 percent. The company’s tax rate is 23 percent.

  

According to MM Proposition I with taxes, what would be the increase in the value of the company after the loan? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

The increase in the value of the company after the loan

Step-1, The Tax shield on the Interest expense for the 2 Years

Years	Loan Balance ($)	Interest expenses at 8.00% [Loan balance x 8.00%]	Tax shield at 23% [Interest expenses x 23%]
1	34,00,000.00	2,72,000.00	62,560.00
2	17,00,000.00	1,36,000.00	31,280.00

Step-2, The Present Value of the Tax shield on the Interest expense

Year	Tax Shield ($)	Present Value Factor (PVF) at 8.00%	Present Value of the Tax Shield [Annual cash flow x PVF]
1	62,560.00	0.925926	57,925.92
2	31,280.00	0.857339	26,817.56
TOTAL			84,743.48

“Therefore, the increase in the value of the company after the loan will be $84,743.48”

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Interest rate and “n” is the number of years.