Question

Suppose that TXY Corp. will currently generate free-cash-flows (FCF) of $300 at the end of the year. TXY has a cost of equity capital of 20%, a market value debt-to-equity ratio of zero, and faces a 21% tax rate. Assuming that TXY's FCF will grow by 3% per year in the future, and any new debt would be risk-free and carry a 5% interest rate, what would be the value of the interest tax shields created if TXY's market value debt-to-equity ratio was changed to 0.30? Round your final answer to two decimals?

Answer 1

The current debt to equity ratio is zero which implies that the debt is zero. Hence, the firm is all-equity financed and its correct discount rate is 20% (equal to the cost of equity capital).

Expected FCF = $ 300, Perpetual FCF growth rate = 3 % = g and Tax Rate = t = 21 %

Therefore, Firm Value = 300 / (0.2-0.03) = $ 1764.706

The firm decides to raise debt such that the debt-equity ratio becomes 0.3. Let the amount of debt raised be $ D

Cost of Debt = Risk-Free Rate = 5 %

Present Value of Interest Tax Shield = ( Cost of Debt x D x Tax Rate) / Cost of Debt = (0.05 x D x 0.21) / 0.05 = D x 0.21

Total Firm Value post raising Debt = 1764.706 + 0.21 x D $

Now as Debt-to-Equity Ratio is 0.3, we have: D / [1764.706 + 0.21D] = (0.3/1.3)

1.3D = 0.3 x 1764.706 + 0.3 x 0.21 x D

1.3D - 0.063D = 0.3 x 1764.706

1.237 D = 529.412

D = 529.412 / 1.237 = $ 427.98

Value of the Interest Tax Shield Created = D x 0.21 = 427.98 x 0.21 = $ 89.8759 ~ $ 89.88