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

Question

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

Book                                                                                   Market
Net working captial $20    $40   Debt                                    Net working capital $20    $40   Debt
Long term assets    $80    $60   Equity                                  Long-term assets     $140   $120 Equity
                             $100   $100                                                                           $160   $160

Assume that MM's theory holds with taxes. Ther is no growth, and the $40 of debt is expected to be permanent. Assume a 40% corporate tax rate.

A)How much of the firm's value is accounted for by the debt-generated tax shield and B) How much better off wil UF's shareholders be if the firm borrows $20 more and uses it to repurchase stock?

Explanation / Answer

a. PV tax shield = .40 X Debt = .40X $40 = $16    b. Annual tax shield = .40 X Interest expense = .40X (.2 X $40) = $8 PV tax shield = $8 X annuity factor(20%, 5 years) = $6.47 The total value of the firm falls by $16 – $6.47 = $9.53, from $160 to $150.47.

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