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Doubt

Manish (B.Com) (26 Points)

22 July 2015

A Ltd and B Ltd are identical in every respect except capital structure.A Ltd doesnot employ debt in its capital structure Whereas B Ltd employs 12% Debenture amounting to Rs 10,00,000.

(1)All assumption of MM model are met.

(2)Income tax rate is 30%

(3)EBIT is Rs 2,50,000

(4)Equity capitalisation rate of A Ltd is 20%

Calculate the value of Both company.

Please can anyone from forum can give me it solution.

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4 Replies

Vikas Gupta (Tax Executive) (530 Points)
Replied 22 July 2015

I am not quite sure but the solution should be as per sheet attached --

Attached File : 868468 20150722121310 mm approach.xlsx downloaded: 197 times

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CA Hussain Bootwala (Auditing and assurance services) (48 Points)
Replied 22 July 2015

@ vikas ji.....What about tax benefit on interest ?

Vikas Gupta (Tax Executive) (530 Points)
Replied 22 July 2015

With reference to the above reply,the Value of the company (V) is actually value of unlevered company. So, in case of B Ltd., since it invests Rs. 10,00,000 in debentures, add this amt to Rs. 455000 and thus now, value of A Ltd. will be Rs. 875000/- and that of B Ltd. it will be Rs. 1455000.

Manish (B.Com) (26 Points)
Replied 22 July 2015

Thanks Vikas,Actually it is solved as follow

Mkt value of B Ltd =Value of unlevered firm + tax sheild

ie =8,75,000 + 10,00,000 * (0.30) = 11,75,000

Query Why tax sheild is added to it?

According to MM aproach cost of capital (ko) remains same irrespective of debt fund is used then how Mkt value of levered firm is increased by tax sheild.??