Assume Schoen Industries of the last problem is subject to income tax at a rate of 40%.

a. Recalculate the value of the firm assuming there is no tax shield associated with debt and compare it to the value calculated in the last problem. That is, assume interest is subtracted in calculating earnings, but is not deductible in calculating taxes. How much value has theoretically been lost to investors as a result of taxes? Which investors suffer the loss, stockholders or bondholders?

b. What is the value of the tax shield associated with the firm’s debt? What is the benefit of debt? Calculate the theoretical value of the firm including the benefit of debt and compare it with the value calculated in the last problem. Who gets the incremental value resulting from the tax shield?

c. Under what conditions, assuming bankruptcy costs are introduced, are investors likely to receive the full benefit of debt calculated in part b?