Question

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

Book-Value Balance Sheet

Net working capital $30 Debt $80

Long term assets $70 Equity $20

________ ___________

$100 $100

Market-Value Balance Sheet

Net working capital $30 Debt $80

Long term assets $170 Equity $120

__________ ____________

$200 $200

Assume that MM’s theory holds except for taxes. There is no growth, and the $80 of debt is expected to be permanent. Assume a 32% 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 r debt =6.5% and r equity = 16.5%?

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, others things equal? Assume a borrowing rate of 6.5%.

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