Question

QUESTION 28

[Q29-33] Assume the M&M with corporate taxes. The corporate tax rate is 40%. Your firm is currently unlevered with 100% equity. As of now, the value of the firm’s equity is $400K, and the firm’s cost of capital is 10%. Assume that your firm can borrow at 4% from a bank.


Suppose that you decided to lever up by reducing equity and increasing debt. As the result, your firm now has $250K in debt. Your firm plans to maintain this debt amount forever. What is the present value of the interest tax shield?

	A.	$40K
	B.	$100K
	C.	$160K
	D.	$80K

QUESTION 29

What is the value of the firm under the new capital structure? (Hint: Use the first M&M proposition with corporate taxes.)

	A.	$100K
	B.	$500K
	C.	$250K
	D.	$400K

QUESTION 30

What is the market value of equity under the new capital structure? (Hint: Use the balance sheet identity.)

	A.	$100K
	B.	$400K
	C.	$250K
	D.	$500K

QUESTION 31

What is the cost of equity under the new capital structure? (Hint: Use the second M&M proposition with corporate taxes.)

	A.	8%
	B.	13.6%
	C.	4%
	D.	10%

QUESTION 32

What is the WACC under the new capital structure?

	A.	8%
	B.	10%
	C.	13.6%
	D.	4%

QUESTION 33

The tradeoff theory suggests that with higher costs of financial distress, it is optimal for a firm to choose lower leverage.

True

False

Please help answer ALL questions and show work.

Answer 1

28) Present value Interest tax shield = Debt x Tax rate
= $250K x 40%
=$100K
Thus ans B. $100K
29) value of the levered firm = value of unleverd firm + Present value Interest tax shield
= $400K + $100K
=$500K
Thus ans B. $500K
30) Market value of equity under the new capital structure = Total vale of firm - Market Value of Debt
=$500K - $250K
=$250K
Thus ans C. $250K
31) Cost of equity under new capital structure = Cost of equity of unleverd firm + (Value of Debt/Value of levered equity) x(1-Tax rate)x(Cost of equity of unleverd firm- Interest rate)
= 10% + (250/250) x (1-0.4) x (10%-4%)
=10% + [1 x 0.6 x 6%]
=10% + 3.6%
=13.60%
Thus ans B. 13.6%

32) After tax caost of debt = Interest rate(1-t)

=4%(1-0.4)

=4%(0.6)

= 2.4%

Statement showing WACC

Particulars (Amount in thousands)	Amount	Weight	Cost of capital	WACC
	a	b	c =axb
Equity	250.00	50%	13.600%	6.80%
Debt	250.00	50%	2.400%	1.20%
	500.00			8.00%

Thus WACC = 8%

Ans A. 8%

33) False

The tradeoff theory suggests that the firm should choose a debt level where the tax savings from increasing leverage are just offset by the incresed probability of incurring the costs of financial distress