3 Replies
CA ADITYA ZANTYE
(BCOM CA CS PROFESSIONAL)
(325 Points)
Replied 25 April 2011
There are two firms P and Q which are identical except P does not use any debt in its capital
structure while Q has Rs. 8,00,000, 9% debentures in its capital structure. Both the firms have
earning before interest and tax of Rs. 2,60,000 p.a. and the capitalization rate is 10%.
Assuming the corporate tax of 30%, calculate the value of these firms according to MM
Hypothesis.
solution
Calculation of Value of Firms P and Q according to MM Hypothesis
Market Value of Firm P (Unlevered)
e
u
K
EBIT (1- t )
V
10 %
2,60,000 (1- 0.30 )
Rs.18,20,000
10 %
Rs.1,82,000
Market Value of Firm Q (Levered)
VE = Vu + DT
= Rs.18,20,000 + (8,00,000 × 0.30)
= Rs.18,20,000 + 2,40,000 = Rs. 20,60,000
this above problem appeared in nov2009 exam.m having doubt that
(1)mm hypothesis assumes that corporate taxes are ignored but still the institute has considered???
(2)why they have taken the value of unlevered firm while calculating value of levered firm??as they both are seperate firm
(3)is the solution correct becoz in ipcc module they have not given such method
CA ADITYA ZANTYE
(BCOM CA CS PROFESSIONAL)
(325 Points)
Replied 25 April 2011
please guys help me out m totally confused
(Guest)
This sum is absolutely correct.
Corporate tax are not ignored in MM hypothesis, actually MM assumed in the first instance that there was no corpoare taxes but this proposition does no hold good in the real world of existence of corporate taxes. They also agreed with it and corrected their view later in this theory.
A levered firm would have greater market value than an unlevered firm. Thus this sum shows thath other things reamining constant, greater the leverage, greater the value of the firm and vice verca.
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