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 $60 of debt is expected to be permanent. Assume a 34% 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 = 7.2% and rEquity = 15.8%? (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 7.2%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Book-Value Balance Sheet Net working capital $ 50 Debt $ 60 Long-term assets 50 Equity 40 $ 100 $ 100

Explanation / Answer

a. Present value of tax shied = tax rate * Market value of Debt = 0.34*$60 = $20.4

b. After tax WACC = Debt rate*(1-tax rate)*(D/D+E) + Equity rate*(E/D+E)

= 7.2%*(1-0.34)*60/255 + 15.8%*195/255

= 13.2%

c.New market value of firm:

Interest on debt = 60*7.2%= $4.32

Annual tax shied = 0.34*$4.32 = $1.47

Present value of tax shied = $1.47*annuity factor(7.2%,5 years)(5years assumed)

=$1.47* 4.08 = $5.997

Total value of firm falls by $20.4-$5.997 = $14.40

Revised Total value of firm = $255-$14.4 = $240.6

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.