Using the Modigliani/Miller propositions with taxes, calculate the change in the value of the firm and the change in the required return on equity if it borrows $2,000,000 and uses the funds to retire $2,000,000 of its equity. The cost of the debt will be 8% and the current required return on equity is 14%. Currently, the firm has 3,000,000 shares outstanding and they are selling for $4.00 each and no debt. The corporate tax rate is 40%.
This solution is to find out Value of a unlevered firm after debt is introduced to retire portion of equity. Here the cost of equity is recalculated.