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IAI Actuarial Core Principles · Business Finance · Personal and corporate taxation

Sagar Foods Ltd (tax rate 30%) issues permanent debt of Rs 50 crore at 9% interest. Assuming Modigliani-Miller with corporate tax, and that the tax shield is discounted at the cost of debt, what is the increase in firm value attributable to the tax shield?

The value increase is Rs 15 crore. Annual interest of Rs 4.5 crore saves tax of Rs 1.35 crore, and capitalising this perpetuity at 9% gives Rs 15 crore, which equals the tax rate of 30% times the Rs 50 crore of debt.

  1. ARs 4.5 crore
  2. BRs 1.35 crore
  3. CRs 15 croreCorrect
  4. DRs 35 crore
  5. Rs 45 crore

Explanation

Annual interest = 4.5 crore; annual tax saving = 1.35 crore. Perpetuity discounted at 9% gives 1.35/0.09 = 15 crore. Check: tD = 0.30 x 50 = 15. Rs 1.35 crore is the annual saving only.

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