CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure
Kaveri Auto Ltd, an unlevered firm, has an expected annual EBIT of ₹10,00,000 in perpetuity. The tax rate is 30% and the cost of equity for the unlevered firm is 14%. The firm plans to raise permanent debt of ₹20,00,000. Using the Modigliani-Miller model with corporate taxes, what will be the value of the levered firm?
The levered firm is worth ₹56,00,000. The unlevered value is ₹7,00,000 divided by 14%, which is ₹50,00,000, and the permanent debt of ₹20,00,000 adds a tax shield of 30% of that debt, which is ₹6,00,000.
- A₹50,00,000
- B₹56,00,000Correct
- C₹70,00,000
- D₹44,00,000
Explanation
Unlevered value = 10,00,000 × (1 − 0.30) / 0.14 = ₹50,00,000. Tax shield = 30% × 20,00,000 = ₹6,00,000. Levered value = 50,00,000 + 6,00,000 = ₹56,00,000. Adding the whole debt amount (₹70,00,000) ignores that only the tax shield adds value.
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