Question I am stumped on: Here are book- and market-value balance sheets of the

Question

Question I am stumped on:

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

Book-Value Balance Sheet: Net working capital$40 Debt$60 Long-term assets 60 Equity 40

Market-Value Balance: SheetNet working capital$40. Debt$60. Long-term assets 180. Equity 160

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 30% corporate tax rate.

a. How much of the firm's market value is accounted for by the debt-generated tax shield?

b. What is United Frypan's after-tax WACC if rDebt = 7.6% and rEquity = 15.4%?

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 a borrowing rate of 7.6%

Thanks so much for your help:)

Explanation / Answer

a) The market value account for the debt generated tax shield = Debt * Tax rate = 60 * 30% = 18

b) After Tax cost of WACC = Cost of Equity * Market Value OF equity /(Total Market value) + Cost of Debt * ( 1-tax rate)* Market value Of Debt/Toal Market value = 15.4% * 160/220 + 7.6% * ( 1- 30%) * 60/220 = 12.65%

c) New Value of Firm (V levered = V Unlevered + Tax shield/(1+r)5 = 220 + 60*30%/( 1+ 7.6%)5 = 232.48

Best of Luck. God Bless

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