Question

The Bellwood Company is financed entirely with equity. The company is considering a loan of $3.9 million. The loan will be repaid in equal principal installments over the next two years and has an interest rate of 9 percent. The company's tax rate is 23 percent. According to MM Proposition 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.)

Please Show all Work and Formulas

Answer 1

As per MM proposition, if debt is taken, value of firm inceases by Present value of interest tax shield.      
Interest rate=       9%
Loan amount=       3900000
Loan principal is repaid in two equal installments. so loan balance at 1 year=       3900000
Interest amount for 1st year= 3900000*9%=       351000
Principal repaid = 3900000/2=       1,950,000.00
So balance at 2 year is 3900000-1950000=       1,950,000.00
Interest for 2nd year = 1950000*9%=       175,500.00
Tax rate =       23%
      
      
Formula for interest tax shield = Interest * tax rate      
for 1st year =351000*23%=   80730  
for 2nd year = 175500*23%=   40365  
      
      
      
P.V. of tax shield = Interest tax shield for year 1/(1+i)^1 + Interest tax shield for year 2/(1+i)^2       
80730/(1+9%)^1 + 40365/(1+9%)^2      
108038.6331      
      
So, Interest tax shield will add $108,038.63 to the Value of firm.