ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation
Dorsay plc is all-equity financed with a cost of equity of 10% and annual perpetual after-tax operating cash flows of $5 million. It issues permanent debt of $20 million at a pre-tax cost of 5%. Corporate tax is 25%. Using MM with tax, what is the value of the geared company?
The geared company is worth $55 million. The ungeared value is $5m divided by 10%, or $50m, and the tax shield on permanent debt adds 25% of $20m, or $5m. Adding the debt itself instead of the shield would be wrong.
- A$55.0 millionCorrect
- B$50.0 million
- C$70.0 million
- D$45.0 million
Explanation
Ungeared value = $5m / 0.10 = $50m. Tax shield on permanent debt = 25% x $20m = $5m. Geared value = $55m. Adding the whole $20m of debt gives $70m, which is wrong because only the tax shield is added.
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