Reference no: EM13478861

1) 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 UF's shareholders be if the firm borrows $20 more and uses it to repurchase stock?

2) What is the relative tax advantage of corporate debt if the corporate tax rate is Tc = .35, the personal tax rate is Tp = .35, but all equity income is received as capital gains and escapes tax entirely (TpE = 0)? How does the relative tax advantage change if the company decides to pay out all equity income as cash dividends that are taxed at 15%?

3) Calculate the weighted-average cost of capital (WACC) for Federated Junkyards of America, using the following information:

• Debt: $75,000,000 book value outstanding. The debt is trading at 90% of book value. The yield to maturity is 9%.
• Equity: 2,500,000 shares selling at $42 per share. Assume the expected rate of return on Federated's stock is 18%.
• Taxes: Federated's marginal tax rate is Tc = .35.

4) 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.