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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

Sundaram Fabrics Ltd, an all-equity firm, has a market value of ₹800 lakh. It plans to issue permanent debt of ₹300 lakh and use the money to buy back equity. The corporate tax rate is 25%. Ignoring personal taxes and costs of financial distress, what is the value of the levered firm under the Modigliani-Miller proposition with corporate taxes?

The levered firm is worth ₹875 lakh. Under the Modigliani-Miller proposition with corporate taxes, value rises above the unlevered value by the tax shield on permanent debt, which is 25% of ₹300 lakh, or ₹75 lakh, added to ₹800 lakh.

  1. A₹875 lakhCorrect
  2. B₹1,100 lakh
  3. C₹725 lakh
  4. D₹1,025 lakh

Explanation

With corporate taxes, the value of the levered firm equals the unlevered value plus the present value of the tax shield, which is tax rate × debt. Tax shield = 25% × 300 = ₹75 lakh, so VL = 800 + 75 = ₹875 lakh. Adding the full debt of ₹300 lakh (₹1,100 lakh) wrongly ignores that only the tax shield adds value.

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