In: Finance
4. Flying High is currently an all-equity firm. It has 1 million shares outstanding and the current share price is $10 per share. The management plans to issue $3 million of perpetual debt and use the proceeds to buy back part of its shares. The debt cost of capital at the new capital structure is 7%. The corporate tax rate is 20%.
Assume the EBIT each year will be high enough so the 30 percent limit on the interest deduction will not be reached. (Therefore the entire interest expense is tax deductible.)
a. Calculate the annual interest tax shield associated with this debt issue.
b. Calculate the present value of the interest tax shields, assuming the interest tax shields have the same risk as the firm's debt.
c. Calculate the value of the firm after the change in capital structure.
d. Calculate the market capitalization after the change in capital structure.