Here are book and marketvalue
balance sheets of the United Frypan Company:

BookValue
Balance Sheet


Net working capital

$

25

Debt

$

60

Longterm assets

75

Equity

40


$

100

$

100


MarketValue
Balance Sheet


Net working capital

$

25

Debt

$

60

Longterm 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 debtgenerated tax shield? (Round
your answer to 2 decimal places.)

PV tax shield

$

b.

What is United Frypan’s aftertax
WACC if r_{debt} = 6.7% and r_{equity} = 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.
