An unlevered firm currently has a value of $100 million.The firm has a tax rate of 30%.The firm wishes to replace $50 million of its equity with $50 million of permanent debt.By increasing its leverage,the PV of the expected costs of financial distress would rise from 0 to $10 million.What is the value of the levered firm if it goes ahead with this plan?

Question

Quizplus · Accepted Answer

The value of the levered firm is $115 million. The PV of the expected costs of financial distress would rise from 0 to $10 million, so the value of the levered firm would be $100 million + $10 million = $110 million. However, the firm is also replacing $50 million of its equity with $50 million of permanent debt, which would increase the value of the firm by $5 million. Therefore, the value of the levered firm would be $110 million + $5 million = $115 million.

An Unlevered Firm Currently Has a Value of $100 Million