CFA Level I · CFA Level I Exam · Capital Structure
A firm with no debt has a value of $500 million and a tax rate of 25%. It issues $200 million of permanent debt and uses the proceeds to repurchase shares. Assuming Modigliani-Miller Proposition I with taxes and no other imperfections, the value of the levered firm is closest to:
The levered firm value is about $550 million. With corporate taxes, value equals unlevered value plus the present value of the interest tax shield, which for permanent debt is tax rate times debt: 0.25 x $200 million = $50 million, added to $500 million.
- A$500 million
- B$550 millionCorrect
- C$700 million
Explanation
VL = VU + t x D = 500 + 0.25 x 200 = 500 + 50 = $550 million. The $500 million option ignores the tax shield; $700 million wrongly adds the full debt amount.
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