IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy
Under Modigliani-Miller with corporate tax but no other imperfections, the value of a geared firm exceeds that of an otherwise identical ungeared firm by the present value of the tax shield. Sundaram Ltd has Rs 50 crore of permanent debt and the corporate tax rate is 30%. What is the value of the gearing benefit?
The gain from gearing is the tax rate multiplied by the permanent debt, which is 30% of Rs 50 crore, equal to Rs 15 crore. This is the present value of the annual interest tax saving in perpetuity.
- ARs 5 crore
- BRs 35 crore
- CRs 20 crore
- DRs 15 croreCorrect
- Rs 30 crore
Explanation
For permanent debt, the value of the tax shield is the tax rate times the debt: 0.30 x 50 = Rs 15 crore. Rs 35 crore results from multiplying by (1 - t), which is a wrong base. Rs 5 crore and Rs 20 crore do not follow from the data.
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