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

 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.