Consider the Modigliani and Miller world of corporate taxes. An unleveraged (all-equity) firm value is $100 million. By adding debt, the annual interest expense is $10 million, the corporate tax rate is 40%, and the discount rate on the tax shield is 10%. What is the gain to leverage or the value added from issuing debt?

Question

Quizplus · Accepted Answer

According to the Modigliani-Miller theorem, the value of the leveraged firm is equal to the value of the unleveraged firm plus the present value of the tax shield. Therefore, the value of the leveraged firm is:

Value of leveraged firm = Value of unleveraged firm + PV of tax shield

Value of leveraged firm = $100 million + ($10 million × 0.4 ÷ 0.1)

Value of leveraged firm = $100 million + $40 million

Value of leveraged firm = $140 million

The gain to leverage or the value added from issuing debt is therefore $40 million. Therefore, the correct answer is C.

Consider the Modigliani and Miller World of Corporate Taxes