Here are book- and market-value balance sheets of the United Frypan Company: Ass

Question

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

Assume that MM’s theory holds except for taxes. There is no growth, and the $55 of debt is expected to be permanent. Assume a 29% corporate tax rate.

a. How much of the firm's market value is accounted for by the debt-generated tax shield?

b. What is United Frypan’s after-tax WACC if rDebt = 7.7% and rEquity = 15.3%? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

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 7.7%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Book-Value Balance Sheet Net working capital $ 35 Debt $ 55 Long-term assets 65 Equity 45 $ 100 $ 100

Explanation / Answer

a. How much of the firm's market value is accounted for by the debt-generated tax shield? a) PV Tax shield = Maket Value of Debt x Tax Rate PV tax shield = $55 x 29% $15.95 b. What is United Frypan’s after-tax WACC if rDebt = 7.7% and rEquity = 15.3%? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) b) WACC Market Value Weights Cost of Capital Equity $150 73.17% 15.30% Debt $55 26.83% 7.70% Total $205 100.00% WACC= we xRe + Wd x Rd x (1-tax) WACC= 73.17% x 15.30% + 26.83% x 7.70 x (1-29%) 12.66% 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 7.7%. (Do not round intermediate calculations. Round your answer to 2 decimal places.) c) Annual tax shield =29% × interest expense = 29% × (7.70% × $55) 1.22815 PV tax shield = $1.228 × PVIFA (7.7%, 5 years) $4.94 The total value of the firm falls by (PV of Debt Tax shield $15.95 $4.94 PV of Interest Tax shield) $11.01 The total value of the firm = $205 - $11.01 $193.99

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