Here are book- and market-value balance sheets of the United Frypan Company: Boo
ID: 2798218 • Letter: H
Question
Here are book- and market-value balance sheets of the United Frypan Company:
Book-Value Balance Sheet
Net working capital
$
25
Debt
$
45
Long-term assets
75
Equity
55
$
100
$
100
Market-Value Balance Sheet
Net working capital
$
25
Debt
$
45
Long-term assets
150
Equity
130
$
175
$
175
Assume that MM’s theory holds except for taxes. There is no growth, and the $45 of debt is expected to be permanent. Assume a 33% 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 = 7.9% and rEquity = 15.1%? (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 7.9%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
Book-Value Balance Sheet
Net working capital
$
25
Debt
$
45
Long-term assets
75
Equity
55
$
100
$
100
Explanation / Answer
a)=debt*tax rate
=45*33%=14.85
b)WACC=(wt of dent*cost of debt)+(wt of equity*cost of equity)
=((45/175)*7.9%*(1-33%))+((130/175)*15.1%)
=12.58%
c)Annual tax shield=tax *interest expense
=33%*(7.9%*45)
=1.17
Present value of tax shiled=1.17*pv(7.9%,7,1,0,0)
=6.11
Total value falls by =14.85-6.11=8.74
Total value of firm=175-8.74=166.26
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