Question

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

Book-Value Balance Sheet
Net working capital	$	20	Debt	$	70
Long-term assets		80	Equity		30
	$	100		$	100

Market-Value Balance Sheet
Net working capital	$	20	Debt	$	70
Long-term assets		175	Equity		125
	$	195		$	195

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 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 = 6.6% and r_Equity = 16.4%? (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 6.6%. (Do not round intermediate calculations. Enter your answer in million rounded to 2 decimal places.)

Answer 1

Share abied - Debt x tax rate Part a: PV tax shield= Debt x tax rate (70*0.21) 14.70 Part b: WACC=rd*(1-t)*wd+re*we (0.066*(1-0.21)*(70/195))+0.164*(125/195) 12.38% Part c: PV tax shield= interest expense x tax rate x annuity factor (6.6%,5) 70*0.066*0.21*4.14449** 4.02 **factor working PVIFA(R%,n) PVIFA(6.6%,5) (1-(1+r)^-n)/ (1-(1.0664-5)/0.066 4.14449 The total value of the firm falls by $14.70 ? $4.02 The total value of the firm = $195 ? $10.68 = 10.68 184.32