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.
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This note was uploaded on 01/17/2011 for the course ACTSC 372 taught by Professor Maryhardy during the Spring '09 term at Waterloo.

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Assignment3 Solution - Assignment 3 Solutions Corporate...

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