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What is the relationship between the value of an unlevered firm and the value of a levered firm once we consider the effect of corporate taxes?

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What is the relationship between the value of an unlevered firm and the value of a levered firm once we consider the effect of corporate taxes?

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The value of a levered firm (who has borrowed) is equal to the value of unlevered firm (whole equity case) plus the interest tax shield. Since, interest of a debt is tax deductible, so it gives benefit in terms of interest tax shield.

If,

Using these parameters, the relationship between the value of an unlevered firm and the value of levered firm once we consider the effects of corporate taxes can be given as shown below:

Where,

Here, T X D represents the interest tax shield. So, the value of levered firm is more than the value of unlevered firm by the amount of interest tax shield once corporate tax is considered.

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1: Plan 1
2: Plan 2
3: 150 000

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A
EPS normal 1.56
EPS expansion 2.02 (+30%)
EPS recession 0.62 (-60%)

B
EPS normal 1.73
EPS expansion 2.04
EPS recession - 0.29

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Question 1
The value of a levered firm is equal to the value of unlevered firm plus the interest tax shield
Question 2
Levered capital structure

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A company has a cost of capital (WACC) equal to 10%. The cost of equity is 12%, the cost of debt is 6.5%,  the tax rate is 20%, and debt represents 30% of the value of the firm (D/V = 30%).

Suppose the company reduces D/V to 20% by issuing new equity and paying down some of its debt. Suppose also that the M&M (Modigliani and Miller) result is correct. If the cost of debt is still 6.5%, then the cost of equity will be __________.
Answer: cost of equity will not changed

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The total systematic risk of a firm’s equity has two parts. What are they?

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The total systematic risk of a firm’s equity has two parts. What are they?

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business risk
financial risk

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The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure.
Proposition 1 The first proposition states that the value of a company is independent of its capital structure. It implies that the value of an all-equity firm is equal to an all-debt firm.

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What are the three determinants of a firm’s cost of equity?

1.     the required rate of return on the firm's assets - Ra

2. the firms cost of debt - Rd

3. the firm's debt-equity ratio - D/E

The total systematic risk of a firm’s equity has two parts. What are they?

The total systematic risk of a firm's equity has two parts: business risk and financial risk. The business risk depends on the firm's assets and operations and is not affected by capital structure. Given the firm's business risk (and its cost of debt), the financial risk is completely determined by financial policy. The firm's cost of equity rises when it increases the use of financial leverage because the financial risk of the equity increases while the business risk remains the same.

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What does M&M Proposition I state?

The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure. At its most basic level, the theorem argues that, with certain assumptions in place, it is irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its profits. Developed in the 1950s, the theory has had a significant impact on corporate finance.

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1. Interest = 645+4% x10000= 1045

EBT = 3741- 1045= 2426

2426 x80 %= 1940.8

1. nothing happens in the income statement, so net income is still 2260,8. Cash dividends reduce cash but have no effect on the het income.

2. 1 is correct cuz the discount rate is the same as interest rate :

Npv=10b - 400m/(1+4%) -400m/(1+4%)^2-…=0

So 2 and 3 is also correct

1. If the current price is fair, then the company neither creates nor destroys value by issuing equity

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What are the three determinants of a firm’s cost of equity?

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What are the three determinants of a firm’s cost of equity?

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the cost of equity is determined by debt-to-equity ratio (DE),
earnings per share (EPS),
total asset turnover ratio (TAT).