Assume that MM’s theory holds with taxes. There is no growth, and the $40 of debt is expected to be permanent. Assume a 40% corporate tax rate.
a. How much of the firm’s value is accounted for by the debt
generated tax shield?
b. How much better off will UF’s a shareholder be if the firm borrows $20 more and uses it to repurchase stock?
Some companies’ debt
equity targets are expressed not as a debt ratio, but as a target debt rating on a firm’s outstanding bonds. What are the pros and cons of setting a target rating, rather than a target ratio?
A project costs $1 million and has a base
case NPV of exactly zero (NPV = 0). What is the project’s APV in the following cases?
a. If the firm invests, it has to raise $500,000 by a stock issue. Issue costs are 15% of net proceeds.
b. If the firm invests, its debt capacity increases by $500,000. The present value of interest tax shields on this debt is $76,000.
The WACC formula seems to imply that debt is “cheaper” than equity
that is, that a firm with more debt could use a lower discount rate. Does this make sense? Explain briefly.