Eccles Inccorporated
Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%.Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.
-Refer to the data for Eccles Incorporated.What is the value of the firm according to MM with corporate taxes?
A) $480,938
B) $534,375
C) $593,750
D) $653,125
E) $718,438

Question

Quizplus · Accepted Answer

According to MM with corporate taxes, the value of the firm can be calculated using the formula V = Vu + (TD), where Vu is the value of the unlevered firm, T is the corporate tax rate, and D is the market value of debt. 
Vu can be calculated using the formula Vu = EBIT / Ku, where Ku is the cost of equity to an unlevered firm. 
So, 
Vu = $100,000 / 16.0% = $625,000 
D = $500,000 
V = $625,000 + (0.25 x $500,000) = $625,000 + $125,000 = $750,000 
However, the question asks for the value of the firm before the tax benefits of debt. So, we need to subtract the tax shield from the value of the firm. 
The tax shield can be calculated as (TD) x T = $500,000 x 0.25 = $125,000 
Thus, the value of the firm according to MM with corporate taxes is $750,000 - $125,000 = $625,000. 
Therefore, the correct answer is C, $593,750.

Eccles Inccorporated Eccles Incorporated, a Zero Growth Firm, Has an Expected EBIT