Here is the market value of the United Frypan Company: VDO = $40.00 (Value of De
ID: 2770232 • Letter: H
Question
Here is the market value of the United Frypan Company: VDO = $40.00 (Value of Debt) VEO = $120.00 (Value of Equity) The tax rate is 40 percent and interest is tax deductible. The company is a perpetual steady state company. Currently the debt is yielding 8 percent. a. How much of the firm's value is accounted for by the debt generated subsidy? (7 points) b. How much better off will UF's shareholders be if the firm borrows $20 more and uses it to repurchase stock? The interest rate will be 10 percent with this higher debt level. (7 points) c. Now suppose that Congress passes a law which will phase out the deductibility of interest for tax purposes after a period of 5 years. What will the new value of the firm be, all other things remaining equal. (6 points)
Explanation / Answer
a.
Debt yeild is 8%. So, before tax rate is = 8/(1-t)=8/(1-.4)=13.33%, t is tax rate= 40%
Saving is 13.33% - 8% = 5.33%
Firm's value by debt generated subsidy = 40/5.33%=$750
b.
Debt yeild is 10% on additional. So, before tax rate is = 10/(1-t)=8/(1-.4)=16.67%, t is tax rate= 40%
Tax saving on Interest on $20 debt = 20*6.67%=$1.34, this amount will be distributed to equity of $100.
c.
On account of new law phasing out tax deductibility on interest, firm wil gain tax benifit of interest for next 5 years. Present value of interest benifit. Since cost of capital is not given here, it can not be calculated. But value of the firm after 5 years, when deductibility of interest for tax purpose will phase out, will be value of Equity & Debt at par i.e 100+40+20 = $160