Tool Manufacturing has an expected EBIT of $85,000 in perpetuity and a tax rate
ID: 2713574 • Letter: T
Question
Tool Manufacturing has an expected EBIT of $85,000 in perpetuity and a tax rate of 35 percent. The firm has $130,000 in outstanding debt at an interest rate of 7.5 percent, and its unlevered cost of capital is 13 percent.
What is the value of the firm according to M&M Proposition I with taxes? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)
Tool Manufacturing has an expected EBIT of $85,000 in perpetuity and a tax rate of 35 percent. The firm has $130,000 in outstanding debt at an interest rate of 7.5 percent, and its unlevered cost of capital is 13 percent.
Explanation / Answer
To find the value of the levered firm we first need to find the value of an unlevered firm .So, the value of the
To find the value of the levered firm we first need to find the value of an unlevered firm. So, the value of the unlevered firm is:
VU = EBIT(1-tC)/RU
VU = ($85,000)(1 - .35)/13
VU = $425,000
Now we can find the value of the levered firm as:
VL = VU + tcD
VL = $425,000 + .35($130,000)
VL = $470,500
Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should continue to increase its debt/equity ratio to maximize the value of the firm