Here are book and market value balance sheets of the United Frypan Company (UF):
Book | Market | ||||||
Net working capital | $ 20 | $ 40 | Debt | Net working Capital | $ 20 | $ 40 | Debt |
Long-term assets | 80 | 60 | Equity | Long-term assets | 140 | 120 | Equity |
| $100 | $100 |
|
| $160 | $160 |
|
Assume that MM’s theory holds with taxes. There is no growth, and the $40 of debt is expected to be permanent. Assume a 40% corporate tax rate.
a. How much of the firm’s value is accounted for by the debt-generated tax shield?
b. How much better off will UF’s shareholders be if the firm borrows $20 more and uses it to repurchase stock?
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