IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy
Under MM with corporate tax but no personal tax or bankruptcy costs, Tarini Ltd is unlevered with value Rs 500 crore. It issues permanent debt of Rs 200 crore, and the corporate tax rate is 25%. What is the value of the levered firm?
The levered firm is worth Rs 550 crore. With corporate tax, value equals the unlevered value plus the present value of the interest tax shield, which for permanent debt is tax rate times debt: 500 + 25% x 200 = 550.
- ARs 700 crore
- BRs 550 croreCorrect
- CRs 500 crore
- DRs 650 crore
- Rs 600 crore
Explanation
VL = VU + T x D = 500 + 0.25 x 200 = 550. The tax shield on permanent debt has a present value equal to tax rate times debt. Rs 500 crore ignores the tax shield, and Rs 700 crore wrongly adds the debt itself.
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