Question

Massey-Moss Corporation has a perpetual EBIT of $3 million and a 40% tax rate. Let’s assume that depreciation expense is zero. It is able to borrow at an interest rate of 14%, whereas its required rate of return on equity in the absence of borrowing is 18%.
a. In the absence of personal taxes, what is the value of the firm when it has no debt? When it has $4 million in debt?
b. If the marginal personal tax rates on stock and bond income are 25% and 30%, respectively, determine the value of the firm when it has no debt and when it has $4 million in debt.

Answer 1

The Data given are:

EBIT=$3 million,Tc= corporate tax=40%=0.40

r_D= rate of interest in presence of borrowing =14% =0.14 , r₀= rate of intereset in the absence of borrowing= 18%=0.18

(a) When the firm has no debt, Let the present value of the firm is V₀  and is given by

= $10 million answer

when the firm has $4 million debt or, let D_l=$ 4 million

the firm value now increase due to corporporate tax shield

Now the value of the firm is given by

= $11.6 million. answer

(b) Now the marginal personal tax on bond is given by T_B=30%

& Marginal personal tax on stock ,T_S=25%

when the firm has no debt: the value of V₀ is the present value available after the corporate and personal tax is given by

V₀=$10 million answer.

now when firm has $ 4 million debt, or D_l=$4 million

then the firm present value V_P Is given by

V_P= $11.43 million answer.