- Tool Manufacturing has an expected EBIT of $35,000 in perpetuity and a tax rate of 35 percent. The firm has $70,000 in outstanding debt at an interest rate of 9 percent, and its unlevered cost of capital is 14 percent. What is the value of the firm according to M&M Proposition I with taxes? Should Tool change its debt-equity ratio if the goal is to maximize the value of the firm? Explain.
To find the value of the levered firm we first need to find the value of an unlevered firm. So, the value of the unlevered firm is:
VU = EBIT(1 – tC)/RU
VU = ($35,000)(1 – .35)/.14
VU = $162,500
Now we can find the value of the levered firm as:
VL = VU + tCD
VL = $162,500 + .35($70,000)
VL = $187,000
Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should continue to increase its debt/equity ratio to maximize the value of the firm.
