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CS Executive · Corporate Accounting and Financial Management · Operational Approach to Financial Decision

Aarav Ltd. (unlevered) has EBIT of ₹10,00,000 and equity capitalisation rate of 20%. The tax rate is 30%. Aarav Ltd. later issues permanent debt of ₹10,00,000 and uses it to retire equity. Using MM with taxes, what is the value of the levered firm?

Unlevered value is ₹10,00,000 × (1 - 0.30) / 0.20 = ₹35,00,000. Adding the tax shield of 30% of ₹10,00,000 debt, i.e. ₹3,00,000, gives a levered firm value of ₹38,00,000.

  1. A₹38,00,000Correct
  2. B₹35,00,000
  3. C₹32,00,000
  4. D₹40,00,000

Explanation

Vu = EBIT(1-T)/Ke = 10,00,000 × 0.7 / 0.20 = ₹35,00,000. Tax shield = 30% × 10,00,000 = ₹3,00,000. Vl = 35,00,000 + 3,00,000 = ₹38,00,000. Option B ignores the shield; option D uses pre-tax EBIT/Ke = ₹50 lakh incorrectly adjusted.

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