Question

Consider the following book value and market value balance sheets. There is no growth, and the...

Consider the following book value and market value balance sheets. There is no growth, and the debt is expected to be permanent at $40.00. The tax rate is 35%. Assume the MM theory holds except for taxes.

Book Value: Networking capital is $20, Long-term Asset is $80, Debt is $40, Equity is $80

Market Value: Networking capital is $20, Long-term Asset is $140, Debt is $40, Equity is $120

(a) What is the value created by the firm?

(b) What is the value of the tax shield?

(c) Suppose Congress passes a law that eliminates the deductibility of interest after 5 years. What will the new value of the firm be as a result? Assume an 8% interest rate.

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Answer #1

(a) value created by firm

the total value of the firm (book value based) = long term assets + net working capital - debt

the total value of the firm (book value based) = 80 + 20 - 40 =60

the total value of the firm (market value based) = 140 + 20 - 40 = 120

so value created by firm = difference in the value of the firm based on market value less book value

value created by firm = 120-60 =60

(b) the value of tax shield = 40 x 0.08 x 35% = 1.12

(C) If rate of interest is 8% and the congress does not allow the interest as tax deductible expense

there will be a reduction in value of firm by 1.12 (tax shield benefit will go away)

GO THORUGH. ANY DOUBTS PLEASE FEEL FREE TO ASK. GIVE POSITIVE FEEDBACK

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