Question

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

Book-Value Balance Sheet
Net working capital	$	70	Debt	$	60
Long-term assets		30	Equity		40
	$	100		$	100

Market-Value Balance Sheet
Net working capital	$	70	Debt	$	60
Long-term assets		150	Equity		160
	$	220		$	220

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 21% corporate tax rate.

a. How much of the firm's market value is accounted for by the debt-generated tax shield? (Enter your answer in million rounded to 2 decimal places.)

b. What is United Frypan’s after-tax WACC if r_Debt = 6.1% and r_Equity = 16.9%? (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 after a grace period of 5 years. What will be the new value of the firm, other things equal? Assume a borrowing rate of 6.1%. (Do not round intermediate calculations. Enter your answer in million rounded to 2 decimal places.)

Answer 1

Firm value always refer to market value ,

Answer a) Market value of tax shield = tax rate * Debt value = 21%*60= $12,6 Million

Answer b) WACC = W_d *R_d*(1-T)+W_e*R_e

i.e. 13.41%

W ACC = [60/220 * 0.061 * (1 -0.33) + 160/220*0.169] = 0.13406

Answer c) Annual Tax shield = Tax * Interest Expenses = 21%*6.1%*60= 0.7686 million.

PV of Tax shield in five years = 0.7686* Annuity factor(6.1%,5)= 3.229

The total value of firm fall by = 12.6 -3.229 = $ 9.371 million

New value of firm = 220 -9.371= $ 210.629 million i.e. $ 210.63 million.