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.)

THE ANSWER IS NOT 227.60.

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

Explanation / Answer

a. According to MM's theory:

In case of permanent debt, Value of firm = Value if all equity financed + (Tax * Debt)

Therefore, firms market value accounted for by debt generated tax shield = (Tax rate) * (debt) = (0.32) * (70) = $22.4

b. rDebt = 7.4%; rEquity = 15.6%

Total Market value of the firm = $250

Total Market Value of Equity = $180; Total Market Value of Equity = $70

WACC = [(E / V) * (rEquity)] + [(D / V) * (rDebt) * (1-Tax rate)]

WACC = [(70 / 250) * (15.6%)] + [(180 / 250) * (7.4%) (1-0.32)]

= 4.368% + 3.623% = 7.991% = 7.99%

WACC = 7.99%

c.

Borrowing rate = 7.4%

Interest expense = 7.4% of 70 = (70 * 0.074) = $5.18

Annual tax shield before eliminating deductibility of interest for tax purpose = (0.32) * (5.18) = $1.6576 = $1.6576

PV Tax shield = $1.6576 * Annuity factor

= 1.6576 * (1 / 0.0799) = $20.7459 (use the previously calculated WACC as discount rate)

Total Value of the firm falls by ($22.40 - $20.7459) = $1.6541

Therefore, new value of the firm = $250.00 - $1.6541 = $248.3459 = $248.35

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