Fundamentals of Corporate Finance, 8^th edition, Brealey, Myers, Marcus,

(Chpt 16, Q19, LO2)

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

Book-value Balance sheet

Net working Capital$ 20Debt$40

Long-term assets80Equity 60

$100$ 100

Market-value Balance sheet

Net working Capital $20Debt$40

Long-term assets140Equity120

$160$160

Assume that MM's theory holds except for taxes. There is no growth, and the $40 of debt is expected to be permanent. Assume a 35% corporate tax rate.

(Chpt 16, Q19, LO2)

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

The firm's value is currently listed as $160, the debt is currently listed as $40, so dividing $40 by $160 equals a debt-generated tax shield of .25 or 25%.

b.What is United Frypan's after-tax WACC if r debt = 8% and r equity = 15%?

WACC = [D / V x (1 - .35) rDebt] + (E / V x rEquity)

=40 / 160 x .65 x .08 + 120 / 160 x .15

=(.25 x .65 x .08) + (.75 x .15)

=0.013 + 0.1125

= 0.1255 or 12.55%

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 8% borrowing rate

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