Here are book- and market-value balance sheets of the United Frypan Company: Ass
ID: 2794017 • Letter: H
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?
PV 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.)
WACC =?
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.)
New Value of the firm =?
Book-Value Balance Sheet Net working capital $ 35 Debt $ 55 Long-term assets 65 Equity 45 $ 100 $ 100Explanation / Answer
a.
PV of tax shield = 0.29 * $55
= $15.95.
b.
WACC = [ $55 / $205 * 0.077 * (1 - 0.29)] + [ $150 / $205 * 0.153]
= 0.01466 + 0.11195
= 0.12661 or 12.66%
c.
Average tax shield = 0.29 * (0.077 * $55)
= $1.23
Presenr value of tax shield = $1.23 * [ 1/ 0.077 - 1 / (0.077 * (1+0.077)5 ) ]
= $1.23 * [ 12.987 - 8.96258]
= $1.23 * 4.02442
= $4.95
Total value of the firm falls by = $15.95 - $4.95
= $11
Total value of firm = $205 - $11
= $194.
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