Question

Assume the tax rate is 21%. State Liquor is an all-equity financing firm. It has restructured to include $1 million in permanent debt with an interest rate of 7%. According to MM 1963 proposition, the value of the firm will increase by ________ due to this change in its capital structure. $70,000 $700,000 $35,000 $210,000

Answer 1

$210,000

Step-by-step explanation:

In this question, we are asked to calculate the amount to which the value of the firm

Will increase to.

Basically what we need to know here is the proposition and how it will affect the value of the firm.

According to MM proposition II , the value of the firm will increase by the debt tax shield when an all equity financed firm is restructured to include debt in the capital structure. This is called Adjusted present value.

Mathematically, this value can be calculated using the formula as follows; (Debt * Interest rate * Tax rate)/ Interest rate

We identify the interest rate as 7% and the tax rate as 21%

=( 1 M * 7% * 21%) /7% = $ 210,000