In this problem, we admit only one real-world factor in an otherwise i

In this problem, we admit only one real-world factor in an otherwise ideal capital market. This real world factor is corporate taxation; specifically that interest payments on debt are deductible while dividend payments are not deductible.

Suppose Delaware East, Inc has until now been an all-equity firm with a market value of $100 mn. Now, the firm decides to increase its leverage by issuing $40 mn. in debt, with the proceeds being used to pay a dividend to shareholders. Assuming that this debt will be a permanent part of the firm’s capital structure, and that the firm’s tax rate is 34%, and accounting for the deductibility of the interest on the debt, what is the total market value of the firm after the recapitalization?
a. $113.6 mn.
b. $100 mn.
c. $73.6 mn.
d. $13.6 mn.
FORMULA: VL=VU+cD

ANSWER

A