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Cycling & Co
Cycling & Co. has an investment opportunity that requires an investment of 24 today. The project has an infinite life. Corporate taxes are 25%. Assume a Modigliani- Miller world, but with taxes (MM with relaxed assumptions). If the company plans to finance this investment with debt at a cost of 9% and plans to pay interest on its debt only, without ever changing the principal (i.e., it won’t raise more debt or pay off the principal), what is the present value of the tax shields?
Select one:
a. 266.67
b. 36.00
c. 104.64
d. 6.00
Expert Solution
Value of Debt (D)= 24
Cost of Debt (Kd) = 9%
Tax rate (T) = 25%
The value of tax shield is given by using the following formula = Value of debt * Cost Of Debt * Tax rate
= D * Kd * T
But, if the debt is constant and not supposed to be changed in the future, the present value is calculated by the following formula = Value of debt * Cost Of Debt * Tax rate / Cost of debt = Value of debt * Tax rate
= D * T
= 24 * 25%
= 6
Thus the present value of the tax shield is 6. Hence option D is correct.
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