Question

Establishment Industries borrows $780 million at an interest rate of 7.4%. Establishment will pay tax at an effective rate of 35%. What is the present value of interest tax shields if:

a. It expects to maintain this debt level into the far future?

Present value

million

b. It expects to repay the debt at the end of 5 years?  

Present value

million

c. It expects to maintain a constant debt ratio once it borrows the $780 million and r_Assets = 10%?

Present value

million

Answer 1

A) PV of tax shield = amount of debt × tax rate

= $780 × 0.35

= $273 million

.

B)

Interest = debt × interest rate

= $780 × 7.4%

= $57.72

Annual tax shield = tax rate × interest expense

= 0.35 × $57.72

= $20.202 million

When a stream of cash flows is paid or received during the whole time period, it is termed as annuity.
PV of annuity is calculated using the following formula:

PV = C × [1-(1+r)^-n]/r

= $20.202 × [1-(1+0.076)^-5]/0.076

= $81.5183

Hence, PV of tax shield = $81.5183

C) in this case, PV of tax shield = annual tax shield / interest rate

= $20.202/10%

= $202.02 million

.

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