Step by Step Assistance

Tuesday, 3 July 2012

Here are book- and market-value balance sheets of the United Frypan Company:


Here are book- and market-value balance sheets of the United Frypan Company:

Book-Value Balance Sheet
  Net working capital
$
25  
  Debt
$
60  
  Long-term assets

75  
  Equity

40  











$
100  

$
100  





















Market-Value Balance Sheet
  Net working capital
$
25  
  Debt
$
60  
  Long-term assets

180  
  Equity

145  











$
205  

$
205  





















Assume that MM’s theory holds except for taxes. There is no growth, and the $60 of debt is expected to be permanent. Assume a 33% corporate tax rate.

a.
How much of the firm’s value is accounted for by the debt-generated tax shield? (Round your answer to 2 decimal places.)

  PV tax shield
$  

b.
What is United Frypan’s after-tax WACC if rdebt = 6.7% and requity = 16.3%? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

  WACC
%  

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 an 6.7% borrowing rate. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

  New value of the firm
$  


Explanation:
Some values below may show as rounded for display purposes, though unrounded numbers should be used for the actual calculations.

a.
PV tax shield = 0.33 × debt = 0.33 × $60 = $19.80

b.

c.
Annual tax shield = 0.33 × interest expense = 0.33 × (0.067 × $60) = $1.33
PV tax shield = $1.33 × annuity factor (6.7%, 5 years)

                   
The total value of the firm falls by $19.80 − $5.48 = $14.32.
The total value of the firm = $205 − $14.32 = $190.68.

Here is Establishment Industries’ market-value balance sheet (Figures in millions):


Here is Establishment Industries’ market-value balance sheet (Figures in millions):







  Net working capital
$
600  
  Debt
$
1,000  
  Long-term assets

3,300  
  Equity

2,900  










  Value of firm
$
3,900  

$
3,900  





















The debt is yielding 5.6%, and the cost of equity is 15.4%. The tax rate is 31%. Investors expect this level of debt to be permanent.

a.
What is Establishment’s WACC? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

  WACC
%  

b.
How would the market-value balance sheet change if Establishment retired all its debt. (Leave no cells blank - be certain to enter "0" wherever required. Do not round intermediate calculations. Round your answers to 1 decimal place.)

New Market-Value Balance Sheet
(figures in millions)
  Net working capital
$  
  Debt
$  
  Long-term assets

  Equity







  Value of firm
$  
  Total
$  














Explanation:
a.


b.
If the firm has no debt, the market value of the firm would decrease by the present value of the tax shield: 0.31 × $1,000 = $310.0.
The value of the firm would be $3,590.0. The long-term assets of the firm (which previously included the present value of the tax shield) will also decrease by $310.0.