Example: - Two firm U as well as L is identical in every respect except that U is unlevered and L is levered. L has Rs. 20Lakh of 8% debt outstanding. The net operating income of both the firms is identical that is Rs. 6Lakh. The corporate tax rate is 35% as well as equity capitalization rate for U is 10%. Find out the value of every firm according to the MM Approach.
Solution:-
(i) Value of Unlevered Firm U:-
EBIT 6, 00,000
Less: Interest Nil
_________
Earning before tax 6,00,000
Less : Tax @ 35% 2,10,000
_________
Earning After Tax 3,90,000
__________
Cost of Equity (Ke) 10%
__________
Value of the firm = EBIT (1-t)/ Ke
Value of the firm (Vu) = 3, 90,000/10% = 39, 00,000
(ii) Value of Levered Firm L
VL = Vu + Dt
V L = 39, 00,000 + 20, 00,000 (.35)
VL = 39, 00,000 + 7, 00,000
VL = 46, 00,000