Question

Tool Manufacturing has an expected EBIT of $51,000 in perpetuity and a tax rate of 21 percent. The firm has $126,000 in outstanding debt at an interest rate of 5.35 percent, and its unlevered cost of capital is 9.6 percent. What is the value of the firm according to M&M Proposition I with taxes? Should the company change its debt-equity ratio if the goal is to maximize the value of the firm? Explain.

Answer 1

We have following information,

Value of outstanding debt = $126,000

Interest rate of debt = 5.35% or 0.0535

Tax rate T = 21% or 0.21

Expected earnings before interest and taxes (EBIT) = $51,000

Unleveraged cost of capital = 9.6% or 0.096

Value of the leveraged firm = Value of unleveraged firm + value of debt * tax rate

Where

Value of unleveraged firm = EBIT*(1-T)/ Unleveraged cost of capital

= $51,000 *(1-0.21) / 0.096

=$419,687.50

Therefore

Value of the leveraged firm = $419,687.50 + $126,000* 21%

= $419,687.50 + $26,460

= $446,147.50

Therefore the value of the firm according to M&M Proposition I with taxes is $446,147.50

MM Proposition I with taxes, the firm can maximize its value by changing its debt-equity ratio as the firm's tax shield (value of debt * tax rate) is added to the value of the firm. But the firm has to take care of its bankruptcy cost while increasing its debt-equity ratio to maximize the value of the firm.