Assume that MM’s theory holds except for taxes. There is no growth, and the $65

Question

Assume that MM’s theory holds except for taxes. There is no growth, and the $65 of debt is expected to be permanent. Assume a 35% corporate tax rate.

How much of the firm's market value is accounted for by the debt-generated tax shield? (Round your answer to 2 decimal places.)

What is United Frypan’s after-tax WACC if rDebt = 6.2% and rEquity = 16.8%? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Now suppose that Congress passes a law that eliminates the deductibility of interest for tax purposes after a grace period of 5 years. What will be the new value of the firm, other things equal? Assume a discount rate of 6.2%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Explanation / Answer

a. The PV of tax shield according to MM model= Tc* D where Tc is the tax rate =35% and D is the debt. =65

So PV of tax shield =65*0.35 = 22.75

b. Weight of debt = Wd= 65/(65+150) = 0.3023

Weight of equity =We = 1-0.3023 = 0.6977

Cost of Debt (after tax) = Rd = 6.2*(1-0.35) = 4.03%

Cost of equity = Re = 16.8%

Hence WACC = We*Re + Wd* Rd = 0.6977*16.8* 0.3023*4.03 = 12.94%

WACC = 12.94%

c. There will be no tax shield and hence the Value of the firm will be the unlevered value which is 215 Million

Assuming there was no debt at all.

So Value of the firm now will be 215 Million

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