<p>Here are book and market value balance sheets of the United Frypan Company (U

Question

<p>Here are book and market value balance sheets of the United Frypan Company (UF):</p>
<p><strong>BOOK</strong></p>
<p>Net working Capital $20&#160;</p>
<p>Debt $40</p>
<p>Long term assets 80/$100</p>
<p>Equity 60/$100</p>
<p><strong>MARKET</strong></p>
<p>Net working Capital $20&#160;</p>
<p>Debt $40</p>
<p>Long term assets 140/$160</p>
<p>Equity 120/$160</p>
<p>Assume the MM&#8217;s theory holds with taxes. There is no growth, and the $40 of debt is expected to be permanent. Assume a 40% corporate tax rate.</p>
<ol>
<li>How much of the firm&#8217;s value is accounted for by the debt-generated tax shield?</li>
<li>How much better off will UF&#8217;s shareholders be if the firm borrows $20 more and uses to repurchase stock?</li>
</ol>

Explanation / Answer

40% is the tax which is 0.4

a)PV tax shield = .40 x Debt

= .40 x $40 = $16 million

b) If it borrows $20 then the debt becomes 20+40 = $60 so

New tax shield PV = .40 x Debt

= .40 x $60 = $24 million

As you can see that the new tax shield is more thus the firm's taxable income reduces. An increase in tax shield leads to decrease of taxable income. Thus the firm has to pay less amount as taxes. In this way it is better off.

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