Question

Tool Manufacturing has an expected EBIT of $87,000 in perpetuity and a tax rate of 22 percent. The firm has $245,000 in outstanding debt at an interest rate of 5.4 percent, and its unlevered cost of capital is 11.3 percent. What is the value of the firm according to M&M Proposition I with taxes? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Value of the firm

Answer 1

The value of the leveraged firm according to M&M Proposition I with taxes is calculated by adding the tax shield from the debt to the perpetuity value of the firm's EBIT post-taxes, and then dividing by the unlevered cost of capital. The calculated value for Tool Manufacturing is $626,469.03.

Step-by-step explanation:

To find the value of the firm according to M&M Proposition I with taxes, we use the formula:

Calculate the tax shield on debt: Interest on debt × Tax rate.

Add the tax shield to the perpetuity value of the firm's EBIT.

The tax shield on the firm's debt is: $245,000 × 5.4% × 22% = $2,911.
To annualize this value because it's a perpetuity, we simply use the tax shield as an ongoing annual saving. We add the EBIT less taxes to the tax shield to find the value of the leveraged firm:

VL = (EBIT × (1 - Tax rate) + Tax shield) / Unlevered cost of capital = ($87,000 × (1 - 22%) + $2,911) / 11.3%.

Calculating, we get:

VL = ($87,000 × 0.78 + $2,911) / 0.113 = ($67,860 + $2,911) / 0.113 = $70,771 / 0.113 = $626,469.03

Hence, the value of the leveraged firm is $626,469.03.