Skip to content

CMA Intermediate · Financial Management and Business Data Analytics · Capital Structure and Capital Stacking

Meera Pharma Ltd has an all-equity capital of Rs 10,00,000 with cost of equity 14%. It plans to substitute Rs 4,00,000 of equity with 9% debt at par. The tax rate is 30%. Under the Modigliani-Miller model with corporate taxes, what is the value of the levered firm relative to the unlevered firm, and what is the gain?

The levered firm is worth Rs 1,20,000 more. Under Modigliani-Miller with corporate taxes, the value gain equals the tax rate multiplied by the debt, which is 30% of Rs 4,00,000. This is the present value of the perpetual interest tax shield.

  1. ALevered firm value is higher by Rs 1,20,000Correct
  2. BLevered firm value is higher by Rs 2,80,000
  3. CLevered firm value is the same, no gain
  4. DLevered firm value is higher by Rs 1,80,000

Explanation

Under MM with taxes, VL = VU + t x D. Gain = 0.30 x 4,00,000 = Rs 1,20,000. Rs 2,80,000 results from using (1 - t) x D, a wrong base. No gain would hold only without corporate taxes.

Did you get it right without looking?

One question tells you little. A timed set on Capital Structure and Capital Stacking shows your real accuracy, how long you take and where you lose marks.

Practise Capital Structure and Capital StackingFree diagnostic mock

More Capital Structure and Capital Stacking questions