An unlevered firm currently has a value of $15 million.The firm has a tax rate of 40%.The firm wishes to replace $5 million of its equity with $5 million of permanent debt.By increasing its leverage,the PV of the expected costs of financial distress would rise from 0 to $1 million.What is the value of the levered firm if it goes ahead with this plan?
A)$10 million
B)$14 million
C)$15 million
D)$16 million
E)$20 million

Question

Quizplus · Accepted Answer

The value of the levered firm can be calculated using the Modigliani-Miller Proposition II with taxes, which states that the value of a levered firm equals the value of an unlevered firm plus the tax shield on debt minus the present value of financial distress costs. Here, the value of the unlevered firm is $15 million, the tax shield on debt is $5 million * 40% = $2 million, and the present value of financial distress costs is $1 million. Therefore, the value of the levered firm is $15 million + $2 million - $1 million = $16 million.

An Unlevered Firm Currently Has a Value of $15 Million