Question

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

Book-Value Balance Sheet
Net working capital	$	80	Debt	$	55
Long-term assets		20	Equity		45
	$	100		$	100

Market-Value Balance Sheet
Net working capital	$	80	Debt	$	55
Long-term assets		145	Equity		170
	$	225		$	225

Assume that MM’s theory holds except for taxes. There is no growth, and the $55 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 = 6.0% and r_Equity = 17.0%? (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 6.0%. (Do not round intermediate calculations. Enter your answer in million rounded to 2 decimal places.)

Answer 1

Answer : (a.) Calculation of  firm's market value is accounted for by the debt-generated tax shield :

Present Value of Tax shield = Market Value od Debt * Tax rate

= 55 million * 21%

= 11.55 million

(b.) Calculation of after Tax WACC

WACC = (After tax cost of Debt * Weight of Debt ) + (Cost of Equity * Weight of Equity)

= [6% * (1 - 0.21) * (55 / 225)] + [17% * (170 / 225)]

= 1.15867% + 12.844%

= 14.00%

(c.) Tax shield on Interest (Annual) = Value of Debt * Borrowing Rate * Tax rate

= 21% * 6% * 55

= 0.693 million.

Present Value of Tax shield in five years = 0.693 * Present value annuity factor @6% for 5 years

= 0.693 million * 4.212363678546

= 2.91916810332 mllion

Fall in value of firm = 11.55 - 2.91916810332

= $ 8.6308318967 million

New value of firm = 225 million - 8.6308318967 million

= $ 216.37 million