Here are book and market value balance sheets of the United Frypan Company. Book value balance...

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

Book value balance sheet

Net working capital 25 Debt 60

Long term assets 75 Equity 40

100 100

Market value balance sheet

Net working capital 25 debt 60

Long term assets 180 equity 145

205 205

Assume that MM's theory holds except for taxes. There is no growth, and the $60 of debt is expected to be permanent. Assume a 33% corporate tax rate.

a. How much of the firm's market value is accounted for by the debt generated tax shield? (PV Tax Shield)

b. What is United Frypan's after tax WACC if r debt= 6.7% and r equity = 16.3% (WACC %)

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 6.7%

Solutions

Expert Solution

Book value
Net working capital	25	Debt	60
Long term asset	75	equity	40
	100		100
Market value
Net working capital	25	Debt	60
Long term asset	180	equity	145
	205		205

1. Present value of tax shield=tax rate×debt

=33%×60

=19.8

2. WACC=Kd (1-t) ×D/V+Ke×E/v

=6.7(1-33%) ×60/205+16.3%×145/205

=4.489%×.29268+16.3%×.707317

=12.84312%

3. Tax shield on borrowing=33 %×( 6.7%×60)

=1.3266

Total value of debt=19.8-1.3266=18.4734

Total value of firm=205-18.4734=186.5266

jeff jeffy answered 1 year ago

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