Question

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

Book-Value Balance Sheet
Net working capital	$	35	Debt	$	40
Long-term assets		65	Equity		60
	$	100		$	100

Market-Value Balance Sheet
Net working capital	$	35	Debt	$	40
Long-term assets		190	Equity		185
	$	225		$	225

Assume that MM’s theory holds except for taxes. There is no growth, and the $40 of debt is expected to be permanent. Assume a 37% 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 = 6.9% and r_Equity = 16.1%? (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. What will be the new value of the firm, other things equal? Assume a borrowing rate of 6.9%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

answer;

a.firm's market value is accounted for by the debt-generated tax shield = tax rate * value of debt = 37% * $40 =0.37*40 = $14.8

b. United Frypan’s after-tax WACC (using market values)

Sources	Amount ($)	Proportion % (W)	Before Tax Cost (%)	After Tax Cost (%)	Weighted Cost
Common Equity	185	82.222		16.10%	13.24
Debts	40	17.778	6.90%	4.347	0.77
Total	225			WACC	14.01

United Frypan’s after-tax WACC (using book values)

Sources	Amount ($)	Proportion % (W)	Before Tax Cost (%)	After Tax Cost (%)	Weighted Cost
Common Equity	60	60.000		16.10%	9.66
Debts	40	40.000	6.90%	4.347	1.74
Total	100			WACC	11.40

United Frypan’s after-tax WACC at market value = 14.01% and WACC at book value = 11.40%

c. Now suppose that Congress passes a law that eliminates the deductibility of interest for tax purposes, the new value of the firm would be $225 - tax shield = $225-$14.8 = $210.2 ( at market values)