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.