1) ABC Inc. has net operating income of= $120,000 per year. ABC utilizes no debt in its capital structure and required rate of return to equity holders is 12%.
a) Compute value of unlevered firm if firm has the marginal tax rate of= 0%.
b) Compute value of unlevered firm if firm has the marginal tax rate of= 30%.
c) Interpret difference in your findings to parts a. and b.
d) If your reply to part a. is less than your reply to part b, can we enhance firm value by taking on debt? If so, will these benefits always continue as we add more and more debt?
2) Provided the given information.
Equity Corporation Debt Corporation
Cost of equity 12% 18%
Debt -------- $2,500,000
Pretax cost of debt -------- 8%
EBIT $500,000 $ 500,000
Compute market value of Equity Corporation, Debt Corporation, and current value of tax shield to Debt Corporation if both companies have the tax rate of= 40%. Suppose there are no financial distress or agency costs and that expected growth of EBIT is zero.