Question

24.Tax Shields and WACC. Here are book- and market value

balance sheets of the United Frypan Company:

(L02)

Book-Value Balance Sheet

Net working capital...........$20 Debt............... $40

Long term assets............. 80 Equity ..............60

$100 $100

Market Value Balance Sheet

Net working capital ..........$20 Debt............... $40

Long term assets............ 140 Equity .............120

$160 $160

Assume that MM's theory holds except for taxes.

There is no growth and the $40 of debt is expected

to be permanent. Assume a 35% corporate tax rate.

a. How much of the firm's value is accounted for by

the debt-generated tax shield?

b. What is United Frypan's after-tax weighted average

cost of capital (WACC)?

c. Now suppose that Parliament 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

being equal? Assume an 8% borrowing rate.

cost of debt 8% cost of equity 15%

Answer 1

a) The Value of the firm that can be contriuted to the debt generated tax shield is DXT which is 40 X 35% = $ 14

b) The WACC based on market value weights is as under:

0.25 Debt Equity wk 1.30% 11.25% 12.55% 5.20% 15% WACC 0.75

c) In such a case the value of a levered firm would be equal to that of an unlevered firm.

Val of a Levered Firm = Val of an Unlevered Firm + D X T

Now, the unlevered firm can be valued at $120 - $ 14 = $ 106. Hence, without the magnifying effect of leverage, the value of the firm would be $106