Question

Here are book- and market-value balance sheets of the United Frypan Company:

Book-Value Balance Sheet
Net working capital	$	30	Debt	$	80
Long-term assets		70	Equity		20
	$	100		$	100

Market-Value Balance Sheet
Net working capital	$	30	Debt	$	80
Long-term assets		170	Equity		120
	$	200		$	200

Assume that MM’s theory holds except for taxes. There is no growth, and the $80 of debt is expected to be permanent. Assume a 32% corporate tax rate.

a. How much of the firm's market value is accounted for by the debt-generated tax shield?

b. What is United Frypan’s after-tax WACC if r_Debt = 6.5% and r_Equity = 16.5%? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

c. Now suppose that Congress passes a law that eliminates the deductibility of interest for tax purposes after a grace period of 5 years. What will be the new value of the firm, other things equal? Assume a borrowing rate of 6.5%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

a). Market Value of debt= 80 $

Tax shield during interest payment on debt= 32%

Assuming cost of debt is 6.5% (as given in part b and c)

Interest amount after tax= 80*6.5(1-.32)%= 3.536 $

Firm's market value accounted by debt generated tax shield= 3.536/200*100 = 1.77%

b). As per book value  

               
fund   cost   w   cost wacc
debt   80   0.8   0.0442(after tax)       0.03536
equity 20   0.2   0.165 0.033
total   100 0.06836
                  
Hence After tax WACC as per book value of firm is 6.84%.

As per market value  

               
fund   cost   w   cost wacc
debt   80   0.4   0.0442(after tax)   0.01768
equity 120   0.6   0.165 0.099
total   200 0.11668

Hence After tax WACC as per market value of firm is 11.67%.

c) Here, Deductibility of interest for tax purposes allowed only for period of 5 years.

As per book value     

               
fund   cost   w       cost    wacc
debt   80 0.8   first 5 years   0.0442(after tax) 0.03536
afterwards    0.065    0.052
equity  20   0.2 0.165 0.033
total   100 0.12036

Hence After tax WACC as per book value of firm is 12.04%.
                      
                      
As per market value  

                  
fund   cost   w cost    wacc
debt   80 0.4   first 5 years   0.0442(after tax) 0.01768
  afterwards 0.065 0.026
equity 120     0.6 0.165    0.099
total   200 0.14268

Hence After tax WACC as per market value of firm is 14.27%.