How does the value of a levered firm compare to the value of an unlevered firm that is otherwise identical?

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How does the value of a levered firm compare to the value of an unlevered firm that is otherwise identical?

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How does the value of a levered firm compare to the value of an unlevered firm that is otherwise identical?

Explanation & AnswerSolution by a verified expert

Explanation

For two similar firms, the value of the levered firm will be equivalent to the sum of the value of the unlevered firm and the value of the side effects due to the leverage.
 
The side effects include the present value of the interest tax shields due to the inclusion of the debt in the capital structure of the firm. The interest tax shields are the allowable deductions from the taxable income declared by a company. Interests payment obligations arises due to the interest liability agreed on the borrowed fund. These interest payment obligations are deducted from the taxable income, which leads to a reduced tax liability of the firm.

Verified Answer

The value of the levered firm is the value of the firm, which has both debt and equity in its capital structure. It can be calculated by adding the value of an unlevered firm and the value of side effects owing to the leverage in the capital structure.

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