Question

Your firm has a market capitalization of 60,000,000 and debt of 20,000,000. It intends to maintain this debt-to-equity ratio. Free cash flows for the next year are 4,000,000. They are expected to grow 5% per year. The equity cost of capital is 0.12. The debt cost of capital is the risk-free rate. The corporate tax rate is 0.20. Calculate the present value of the tax shield assuming it is risk free.

Answer 1

The ratio between cost of debt and cost of equity will be same as the ratio between companies total debt and equity. Total debt of the firm is 20 million and total equity (in this case the market capitalization) = 60 million.

Hence, debt to equity ratio = Total liability / shareholders equity

In this case, since no details are available on other liabilties we have assumed debt to be the only liability.

Debt to Equity = 20 mil / 60 mil = 1/3

Also, cost of debt (kd) / Cost of Equity (ke) = 1/3

Kd / 0.12 = 1/3

Therefore Kd = 0.04

Free cash flow -- 4 million

Less cost of debt (20 million * 0.04) -- 0.8 million

Therefore, Net income = 3.2 million.

Tax shield = Taxable expense * tax rate

= 0.8 million * 0.2 = 160,000