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1) The market value of ABC Company is given below:

VDO = $40.00 (Value of Debt)
VEO = $120.00 (Value of Equity)

Tax rate is 40% and interest is tax deductible. Company is perpetual steady state company. Presently the debt is yielding 8%.

a) How much of firm's value is accounted for by debt generated subsidy?

b) How much better off will shareholders be if firm borrows $20 more and uses it to repurchase stock? Interest rate will be 10% with this higher debt level.

c) Now assume that Congress passes a law which will phase out the deductibility of interest for tax purposes after a period of five years. What will the new value of firm be, all other things remaining equal?

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  • Category:- Basic Finance
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