Question

Here are book- and market-value balance sheets of the United Frypan Company (figures in $ millions):

Book-Value Balance Sheet
Net working capital	$	60	Debt	$	65
Long-term assets		40	Equity		35
	$	100		$	100

Market-Value Balance Sheet
Net working capital	$	60	Debt	$	65
Long-term assets		155	Equity		150
	$	215		$	215

Assume that MM’s theory holds except for taxes. There is no growth, and the $65 of debt is expected to be permanent. Assume a 21% corporate tax rate.

c. Now suppose that Congress passes a law that eliminates the deductibility of interest for tax purposes after a grace period of 5 years. What will be the new value of the firm, other things equal? Assume a borrowing rate of 6.2%. (Do not round intermediate calculations. Enter your answer in million rounded to 2 decimal places.)

Answer 1

C.

The value of the firm will fall by:

Tax generated tax shield - Present value of the tax shield for 5 years

= 65*0.21 - Present value of the tax shield for 5 years

= 13.65 - Present value of the tax shield for 5 years

5 years of tax shield can be considered as an annuity & its PV can be calcualted using PV annuity factor or Excel as:

65 6.20% Debt borrowing rate years Tax rate Annual tax shield 21% 0.8463 =Debt*borrowing rate*Tax rate PV of 5 years' tax shield $ 3.55 = PV(6.2%,5, Annual tax shield)

So the value of the firm will fall by:

13.65-3.55= $10.10

Thus the new value of the firm will be = $100-$10.10 = $89.9