Discuss Modigliani and Miller\'s Propositions I in a world with corporate tax bu

Question

Discuss Modigliani and Miller's Propositions I in a world with corporate tax but no other market frictions nor distress costs. List the basic assumptions, results, and intuition of the model. Based on this model, if the original unlevered firm value is $100 million, the corporate tax rate is 20%, and the CFO is planning to carry out a leveraged recapitalization to add a permanent debt of $30 million. The interest rate for the debt is 6% for the coming year. The unlevered equity requires 10% annual return. What’s the levered firm value? What’s the value of levered equity?

Explanation / Answer

Value of levered firm = Value of unlevered firm + Debt x tax rate

= 100 + 30 x 20% = $106 million

Value of levered equity = Firm Value - Debt = 106 - 30 = $76 million

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