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 (K_e)                                                                 10%

                                                                                             __________

Value of the firm = EBIT (1-t)/ K_e

Value of the firm (Vu) = 3, 90,000/10%  = 39, 00,000

(ii) Value of Levered Firm L

V_L = V_u + D_t

V _L  = 39, 00,000 + 20, 00,000 (.35)

V_L = 39, 00,000 + 7, 00,000

V_L = 46, 00,000