An unlevered firm currently has a value of $40 million.The firm has a tax rate of 40%.The firm wishes to replace $10 million of its equity with $10 million of permanent debt.What is the value of the levered firm if it goes ahead with this plan?
A)$42 million
B)$50 million
C)$40 million
D)$44 million
E)$45 million

Question

Quizplus · Accepted Answer

The value of levered firm is calculated as the value of unlevered firm + tax shield from the interest payments on the new debt. The tax shield can be calculated as the interest rate on the new debt times the tax rate times the amount of new debt ($10 million). The interest rate on the new debt is not provided, so we can't calculate the exact value, but we can estimate. If we assume an interest rate of 5%, then the tax shield would be 5% x 40% x $10 million = $2 million. Thus, the value of the levered firm would be $40 million + $2 million = $42 million. Therefore, the correct answer is D.

An Unlevered Firm Currently Has a Value of $40 Million