Question

Bird Enterprises has no debt. Its current total value is $47.2 million. Assume debt proceeds are used to repurchase equity.
a. Ignoring taxes, what will the company’s value be if it sells $18.5 million in debt? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, round your answer to the nearest whole number, e.g., 1,234,567.)
b. Suppose now that the company’s tax rate is 21 percent. What will its overall value be if it sells $18.5 million in debt?

Answer 1

Answer:

a) as there is no taxes, under MM proposition the value of the firm remains the same at 472.2 millions

b) as there is income taxes, the value of the firm increases if levered As the interest expense provides a tax shield:

18,500,000 x 21% = 3,885,000

47,200,000 + 3,885,000 = 51,085,000‬

Explanation:

The reasoning behind is that while dividends (reutrn on equity) are not considered expenses interest (debt "return") do. Thus, financing with debt generates a positive tax shield as we decrease our fiscal obligations