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Assignment3 Solution

# Assignment3 Solution - Assignment 3 Solutions Corporate...

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Assignment 3 Solutions Corporate Finance II (ACTSC372) Problem 1: a. Modigliani-Miller Proposition I states that in a world with corporate taxes: V L = V U + T C B Where: V L = the value of a levered firm V U = the value of an unlevered firm T C = the corporate tax rate B = the value of debt in a firm’s capital structure In this problem: V L = \$1,700,000 B = \$500,000 T C = 0.34 If the firm were financed entirely by equity, the value of the firm would be: V U = V L – T C B = \$1,700,000 – (0.34)(\$500,000) = \$1,530,000 Therefore, the value of this firm would be \$1,530,000 if it were financed entirely by equity. b. While the firm generates \$306,000 of annual earnings before interest and taxes, it must make interest payments of \$50,000 (= \$500,000 * 0.10). Interest payments reduce the firm’s taxable income. Therefore, the firm’s pre-tax earnings are \$256,000 (= \$306,000 - \$50,000). Since the firm is in the 34% tax bracket, it must pay taxes of \$87,040 (= 0.34 * \$256,000) at the end of each year. Therefore, the amount of the firm’s annual after-tax earnings is: \$168,960 (= \$256,000 - \$87,040). These earnings are available to the stockholders. The following table summarizes this solution: EBIT \$306,000 Interest 50,000 Pre-Tax Earnings 256,000 Taxes at 34% 87,040 After-Tax Earnings 168,960

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Problem 2: a. The value of an all-equity firm is the present value of its after-tax expected earnings: V U = [(EBIT)(1-T C )] / r 0 Where: V U = the value of an unlevered firm EBIT = the firm’s expected annual earnings before interest and taxes T C = the corporate tax rate r 0 = the after-tax required rate of return on an all-equity firm In this problem: EBIT = \$2,500,000 T C = 0.34 r 0 = 0.20 The value of Strider Publishing is: V U = [(EBIT)(1-T C )] / r 0 = [(\$2,500,000)(1 - 0.34)] / 0.20 = \$8,250,000 Therefore, the value of Strider Publishing as an all-equity firm is \$8,250,000. b. Modigliani-Miller Proposition I states that in a world with corporate taxes: V L = V U + T C B Where: V L = the value of a levered firm V U = the value of an unlevered firm T C = the corporate tax rate B = the value of debt in a firm’s capital structure In this problem: V U = \$8,250,000 T C = 0.34 B = \$600,000 The value of Strider Publishing will be: V L = V U + T C B = \$8,250,000 + (0.34)(\$600,000) = \$8,454,000 Therefore, the value of Strider Publishing Company will be \$8,454,000 if it issues \$600,000 of debt and repurchases stock. c. Since interest payments are tax deductible, debt lowers the firm’s taxable income and creates a tax shield for the firm. This tax shield increases the value of the firm. d. The Modigliani-Miller assumptions in a world with corporate taxes are: 1. There are no personal taxes. 2. There are no costs of financial distress. 3. Perpetual cash flow 4. No transaction costs 5. Individuals and corporations can borrow at the same rate 6. Complete information
Problem 3: a. The expected return on a firm’s equity is the ratio of annual after-tax earnings to the market value of the firm’s equity. Green expects \$1,500,000 of pre-tax earnings per year. Because the firm is subject to a corporate tax rate of 40%, it must pay \$600,000 worth of taxes every year. Since the firm has no debt in its capital structure and makes no interest payments, Green’s annual after-tax expected earnings are \$900,000 (= \$1,500,000 - \$600,000).

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Assignment3 Solution - Assignment 3 Solutions Corporate...

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