Question

Problem 16-19 MM Proposition I with Taxes The Bellwood Company is financed entirely with equity. The company is considering a loan of $3.4 million. The loan will be repaid in equal installments over the next two years and has an interest rate of 8 percent. The company's tax rate is 24 percent. According to MM Proposition I with taxes, what would be the increase in the value of the company after the loan? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

According to MM Proposition I with taxes, the increase in the value of the Bellwood Company after taking on a $3.4 million loan at an 8 percent interest rate with a 24 percent tax rate would be the present value of the tax shield, approximately $130,560 over two years.

Step-by-step explanation:

To calculate the increase in the value of the company after the loan according to MM Proposition I with taxes, we must consider the tax shield benefit of the debt.

The interest payment on the loan provides a tax shield, which is the tax rate times the interest on the debt. Since the company is planning to take on a loan of $3.4 million at an 8 percent interest rate and the company's tax rate is 24 percent, the annual tax shield is 0.08 × $3.4 million × 0.24.

This amounts to an annual tax shield of $65,280. Over the two years, this will sum up to $130,560. According to MM Proposition I with taxes, the value of the company increases by the present value of this tax shield.

Assuming that the tax shield is realized at the end of each year and ignoring the effects of discounting due to the short timespan, the increase in the value of the company would be approximately $130,560.