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 $100 | 60 $100 | Equity | Long-term assets | 140 $160 | 120 $160 | Equity |
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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