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 $70 of debt is expected to be permanent. Assume a 32% 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 = 7.4% and rEquity = 15.6%? (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 7.4%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Book-Value Balance Sheet Net working capital $ 50 Debt $ 70 Long-term assets 50 Equity 30 $ 100 $ 100

Explanation / Answer

a) PV Tax Shield = Tax Rate x Debt = 32% x 70 = $22.40 million

b) WACC = wd x rd x (1 - tax) + we x re = (70/250) x 7.4% x (1 - 32%) + (180/250) x 15.6% = 12.64%

c) Value of firm = Original Firm Value - PV Tax Shield = 250 - 22.40 = $227.60

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