What is the change in value for a firm with $1 million in equity, $1 million in permanent debt at a 10% interest rate, and a 35% tax rate if MM I is modified to recognize corporate taxes?

Question

Quizplus · Accepted Answer

With the modification of MM I to recognize corporate taxes, there is a benefit to having debt in the capital structure due to the tax shield provided by the interest payments. The value of the firm with debt is calculated as the value of the all-equity financed firm plus the present value of the tax shield. In this case, the present value of the tax shield is calculated as the tax rate (35%) multiplied by the interest payment ($100,000), which equals $35,000. Therefore, the total value of the levered firm is $1,350,000 ($1,000,000 + $350,000). This represents an increase in value of $350,000 compared to the all-equity financed firm.

What Is the Change in Value for a Firm with $1