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ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation

Orion Group wants to set a target gearing for its financial strategy. Under Modigliani and Miller with corporate tax, the value of a geared company equals the value of an ungeared company plus which item?

With corporate tax, the geared firm's value equals the ungeared value plus the present value of the interest tax shield, which for irredeemable debt is the tax rate multiplied by the market value of debt. Distress costs are not part of that MM formula.

  1. AThe present value of the tax shield on debt interest, being tax rate multiplied by the market value of debt (for irredeemable debt)Correct
  2. BThe book value of debt
  3. CThe cost of debt multiplied by the tax rate, divided by the equity value
  4. DThe expected cost of financial distress

Explanation

With corporate tax, Vg = Vu + T x D for irredeemable debt, where T x D is the present value of the tax shield. The book value of debt is not the adjustment. Financial distress costs are subtracted in trade-off theory, not part of MM with tax.

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