Assignment 3 Solutions
Corporate Finance II (ACTSC372)
Problem 1:
a. Modigliani-Miller Proposition I states that in a world with corporate taxes:
V
L
= V
U
+ T
C
B
Where:
V
L
= the value of a levered firm
V
U
= the value of an unlevered firm
T
C
= the corporate tax rate
B = the value of debt in a firm’s capital structure
In this problem:
V
L
= $1,700,000
B = $500,000
T
C
= 0.34
If the firm were financed entirely by equity, the value of the firm would be:
V
U
= V
L
– T
C
B = $1,700,000 – (0.34)($500,000) =
$1,530,000
Therefore, the value of this firm would be $1,530,000 if it were financed entirely by
equity.
b. While the firm generates $306,000 of annual earnings before interest and taxes, it must
make interest payments of $50,000 (= $500,000 * 0.10).
Interest payments reduce the firm’s taxable income.
Therefore, the firm’s pre-tax earnings are $256,000 (= $306,000 - $50,000).
Since the firm is in the 34% tax bracket, it must pay taxes of $87,040 (= 0.34 * $256,000) at the
end of each year.
Therefore, the amount of the firm’s annual after-tax earnings is:
$168,960 (= $256,000 - $87,040).
These earnings are available to the stockholders.
The following table summarizes this solution:
EBIT
$306,000
Interest
50,000
Pre-Tax Earnings
256,000
Taxes at 34%
87,040
After-Tax Earnings
168,960