Note: an assumption in the MM theory: a firm is viewed as perpetuity. Please think
through this exercise.
15.15
a.
The value of an all-equity firm is the present value of its after-tax expected earnings:
VU = [(EBIT)(1-TC)] / r0
where
VU
EBIT
TC
r0
= the value of an unlevered firm
= the firm’s expected annual earnings before interest and taxes
= the corporate tax rate
= the after-tax required rate of return on an all-equity firm
In this problem:
EBIT = $2,500,000
TC
= 0.34
r0
= 0.20
The value of Strider Publishing is:
VU = [(EBIT)(1-TC)] / r0
= [($2,500,000)(1 - 0.34)] / 0.20
= $8,250,000
Therefore, the value of Strider Publishing as an all-equity firm is $8,250,000.
b.
Modigliani-Miller Proposition I states that in a world with corporate taxes:
VL = VU + TCB
where
VL
VU
TC
B
= the value of a levered firm
= the value of an unlevered firm
= the corporate tax rate
= the value of debt in a firm’s capital structure
In this problem:
VU = $8,250,000
TC = 0.34
B = $600,000
The value of Strider Publishing will be:
VL = VU + TCB
= $8,250,000 + (0.34)($600,000)
= $8,454,000
Therefore, the value of Strider Publishing Company will be $8,454,000 if it issues
$600,000 of debt and repurchases stock.
c. Since interest payments are tax deductible, debt lowers the firm’s taxable income and creates
a tax shield for the firm. This tax shield increases the value of the firm.
d.
The Modigliani-Miller assumptions in a world with corporate taxes are:
1. There are no personal taxes.
2.
3.
There are no costs of financial distress.
The debt level of a firm is constant through time.