Jiang Chan Corporation has earnings before interest and taxes of $4.5 million and a 30% tax rate. It is able to borrow at an interest rate of 12%, whereas its equity capitalization rate in the absence of borrowing is 16%. The earnings of the company are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. In the presence of corporate but no personal taxes, what is the value of the company in an M&M world with no financial leverage? With $5 million in debt? With $10 million in debt?
Answer:
Value of firm if unlevered:
Earnings before interest and taxes $ 4,500,000
Interest 0
Earnings before taxes $ 4,500,000
Taxes (40%) 1,350,000
Earnings after taxes $ 3,150,000
Equity capitalization rate, ke ÷ 0.16
Value of the firm (unlevered) $19,687,500
Value with $5 million in debt:
Value of levered firm = Value of firm if unlevered + PV of tax-shield benefits of debt
= $19,687,500 + ($5,000,000) (0.30)
= $21,187,500
Value with $10 million in debt:
= $19,687,500 + ($10,000,000)(0.30)
= $22,687,500
Due to the tax subsidy, the firm is able to increase its value in a linear manner with more debt.
