Here is the market value of the United Frypan Company: VDO = $40.00 (Value of De
ID: 2770390 • 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?
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.
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.
Explanation / Answer
Value of the debt generated subsidy = $40 x 0.4 = $16
Value of debt generated subsidy after new debt = $40 + ($20 x 0.4) = $48
Value of the levered firm = $48 + $120 = $168
Value of equity = $168 - $60 = $108
Reduction in equity = $120 - $108 = $12
So, the UF’s shareholder will be: $12/$120 = 10% better-off, with the new debt.
C) Using the equation Debt * the tax rate is appropriate if the tax shield is a perpetuity. Here the tax shield provides benefit for only 2 years (the grace period of 5 years means the firm can deduct interest from taxable income for 2 more years. So, you must calculate the interest tax shield and discount it for year 1 and 2.
We also need to calculate the weighted average interest rate.
Weighted average interest rate = [($40/$60) x 0.08] + [($20/$60) x 0.10] = 8.67%
V(L)=168 + (60*.0867*0.4)/1.0867+(60*.0867*.4)/1.08672 = $171.68