Book- and market-value balance sheets

Reference no: EM13201800

Here are book- and market-value balance sheets of the United Frypan Company (UF):

Book Market

Net Working Capital $20 $40 Debt Net Working Capital $20 $40 Debt

Long-term asset $80 $60 Equity Long-term Assets $140 $120 Equity

$100 $100 $160 $160

(The middle-of-the-road party was founded in 1961 by Miller and Modigliani, always referred to as "MM", when they published a proof that dividend policy is irrelevant in a world without taxes, transaction costs, or other market imperfections. MM argued as follows. Suppose your firm has settled on its investment program. You have a plan to finance the investments with cash on hand, additional borrowing, and reinvestment of future earnings. Any surplus cash is to be paid out as dividends.) 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 UFs shareholders be if the firm borrows $20 more and uses it to repurchase stock?

Reference no: EM13201800

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