Chapter 15

Debt and Taxes

15-1. Pelamed Pharmaceuticals has EBIT of $325 million in 2006. In addition, Pelamed has interest
expenses of $125 million and a corporate tax rate of 40%.

Assumptions EBIT 325 a. What is Pelamed’s 2006 net income?

Interest Expens 125 (EBIT - Interest Expenses)*(1-tc)
Tc 40% 120
b. What is the total of Pelamed’s 2006 ne
245
c. If Pelamed had no interest expenses, w
compare to your answer in part (b)?
195
’s 2006 net income?
enses)*(1-tc)

of Pelamed’s 2006 net income and interest payments?

o interest expenses, what would its 2006 net income be? How does it
nswer in part (b)?
Chapter 15
Debt and Taxes

15-2. Grommit Engineering expects to have net income next year of $20.75 million and free cash flow
of $22.15 million. Grommit’s marginal corporate tax rate is 35%.

Assumptions EBIT 20.75 a. If Grommit increases leverage so that its interest expens
FCF 22.15 income change?
Tc 35% (EBIT - Interest Expenses)*(1-tc)
New assumption
Interest expenses rises 1

b. For the same increase in interest expense, how will free

free cash flow is not affected by interest expenses

15-3. Suppose the corporate tax rate is 40%. Consider a firm that earns $1000 before interest and
taxes each year with no risk. The firm’s capital expenditures equal its depreciation expenses each
year, and it will have no changes to its net working capital. The risk-free interest rate is 5%.

Assumptions EBIT 1000 a. Suppose the firm has no debt and pays out its net income as
rf 5% the value of the firm’s equity?
Tc 40% all equity
net income 600 perpetuity

b. Suppose instead the firm makes interest payments of $500 p

equity? What is the value of debt?
interest year 500
net income 300 perpetuity
MVD 10000
(assuming perpetituiy)

What is the difference between the total value of the firm with
leverage?
MVF leverage 16000
MVF unlevered 12000
d free cash flow

e so that its interest expense rises by $1 million, how will its net

20.1

rest expense, how will free cash flow change?

terest expenses

and pays out its net income as a dividend each year. What is

12000 MVE

es interest payments of $500 per year. What is the value of

6000 MVE

he total value of the firm with leverage and without

15-4. Braxton Enterprises currently has debt outstanding of $35 million and an interest rate of 8%.
Braxton plans to reduce its debt by repaying $7 million in principal at the end of each year for
the next five years. If Braxton’s marginal corporate tax rate is 40%, what is the interest tax
shield from Braxton’s debt in each of the next five years?

Assumptions 0 1 2 3 4 5
Debt 35 Debt 35 28 21 14 7 0
interest 8% Interest 2.8 2.24 1.68 1.12 0.56 0
tc 40% tax 1.12 0.896 0.672 0.448 0.224 0

15-5. Your firm currently has $100 million in debt outstanding with a 10% interest rate. The terms of
the loan require the firm to repay $25 million of the balance each year. Suppose that the
marginal corporate tax rate is 40%, and that the interest tax shields have the same risk as the
loan. What is the present value of the interest tax shields from this debt?

Assumptions 0 1 2 3 4
Debt 100 Debt 100 75 50 25 0
interest 10% Interest 10 7.5 5 2.5
tc 40% tax 0 4 3 2 1
0 3.636364 2.479339 1.50263 0.683013
Chapter 15
Debt and Taxes
Chapter 15
Debt and Taxes

15-6. Arnell Industries has just issued $10 million in debt (at par). The firm will pay interest only on
this debt. Arnell’s marginal tax rate is expected to be 35% for the foreseeable future.

Assumptions a. Suppose Arnell pays interest of 6% per year on its debt. What is its annu
Debt 10 shield?
interest 6% annual interest tax shield = Debt*interest*tc 0.21
tc 35% b. What is the present value of the interest tax shield, assuming its risk is th
PVTS 3.5
c. Suppose instead that the interest rate on the debt is 5%. What is the pres
interest tax shield in this case?
annual interest tax shield = Debt*interest*tc 0.175
PVTS 3.5
ts debt. What is its annual interest tax

ld, assuming its risk is the same as the loan?

t is 5%. What is the present value of the

Chapter 15
Debt and Taxes

Ten years have passed since Arnell issued $10 million in perpetual interest only debt with a 6%
annual coupon, as in Problem 6. Tax rates have remained the same at 35% but interest rates
have dropped so Arnell’s current cost of debt capital is 4%.

Assumptions a. What is Arnell’s annual interest tax shield?

Debt 10 annual interest tax shield = Debt*interest*tc 0.21
perpetual interest 6%
Tc 35% b. What is the present value of the interest tax shield today?
rd 4% PVTS 5.25 (if we have rd we should discount by rd)

Another way PVTS =tc.D

MVD (face value debt*interest)/rd 15
ould discount by rd)

5.25
Chapter 15
Debt and Taxes

15-8. Bay Transport Systems (BTS) currently has $30 million in debt outstanding. In addition to 6.5%
interest, it plans to repay 5% of the remaining balance each year. If BTS has a marginal
corporate tax rate of 40%, and if the interest tax shields have the same risk as the loan, what is
the present value of the interest tax shield from the debt?
Assumptions annual interest tax shield = Debt*interest*tc
Debt 30 0.78
perpetual interest 6.50% As the outstanding balance declines, so will the interest tax shield
Tc 40.00% growing perpetuity 6.782609
growth (of debt) -5%

15-9. Safeco Inc. has no debt, and maintains a policy of holding $10 million in excess cash reserves,
invested in risk-free Treasury securities. If Safeco pays a corporate tax rate of 35%, what is the
cost of permanently maintaining this $10 million reserve? (Hint: what is the present value of the
additional taxes that Safeco will pay?)
Assumptions
all equity Debt -10
cash 10 PVTS (D*tc) -3.5
tc 35%
risk free securities
tion to 6.5%

st tax shield
Chapter 15
Debt and Taxes

15-10. Rogot Instruments makes fine Violins and Cellos. It has $1 million in debt outstanding, equity
valued at $2 million, and pays corporate income tax at rate 35%. Its cost of equity is 12% and its
cost of debt is 7%.
Assumptions a. What is Rogot’s pretax WACC?
Debt 1 re 12% We*re+Wd*rd 10.333%
equity 2 rd 7%
corporate tax 35% D/E 0.5 b. What is Rogot’s (effective after-tax) WACC?
We 0.666667 We*re +Wd*rd *(1-tc) 9.517%
Wd 0.333333
er-tax) WACC?
Chapter 15
Debt and Taxes

15-11. Rumolt Motors has 30 million shares outstanding with a price of $15 per share. In addition,
Rumolt has issued bonds with a total current market value of $150 million. Suppose Rumolt’s
equity cost of capital is 10%, and its debt cost of capital is 5%.
Assumptions a. What is Rumolt’s pretax weighted average cost of capital?
Shares 30 rd 5% We*re+Wd*rd 8.750%
Price 15 re 10%
Equity 450 we 0.75 b. If Rumolt’s corporate tax rate is 35%, what is its after-tax weighted av
Debt 150 wd 0.25 We*re +Wd*rd *(1-tc) 8.313%
tc 35%
cost of capital?

t is its after-tax weighted average cost of capital?

Chapter 15
Debt and Taxes

15-12. Summit Builders has a market debt-equity ratio of 0.65 and a corporate tax rate of 40%, and it
pays 7% interest on its debt. The interest tax shield from its debt lowers Summit’s WACC by
what amount?
D/E 0.65 Transform D/E to find D/V D/E/(1+D/E) 0.394
tc 40% Transform D/V to find E/V D/V(1-D/V) 0.650
r 7% Wacc= PretaxWacc * D/V*(1-tc)

15-13. NatNah, a builder of acoustic accessories, has no debt and an equity cost of capital of 15%.
Suppose NatNah decides to increase its leverage and maintain a market debt-to-value ratio of
0.5. Suppose its debt cost of capital is 9% and its corporate tax rate is 35%. If NatNah’s pretax
WACC remains constant, what will its (effective after-tax) WACC be with the increase in
leverage?
Wacc = 10.43%
all equity D/E 0.5
re 15% rd 9%
tc 35%

15-14. Restex maintains a debt-equity ratio of 0.85, and has an equity cost of capital of 12% and a debt
cost of capital of 7%. Restex’s corporate tax rate is 40%, and its market capitalization is $220
million
D/E 0.85 a. If Restex’s free cash flow is expected to be $10 million in one year, what constant expected
re 12% future growth rate is consistent with the firm’s current market value?
rd 7% FCF = 10
tc 40% MVF = FCF/(wacc-g) = MVF = 10/(wacc-g)
MVE 220 solve for wacc
D/E 0.85 wacc 8.416%
D/V =0,85/1,85
D/E=1/1,85
re 12%
rd 7%
tc 40%
solve for MVF solve for g
VL=E+D VL=220+D 407= 10/(0,08416-g)
D+E 1.85 g= 5,96%
VL=E*(D+E) 407
constant expected
15-15. Acme Storage has a market capitalization of $100 million and debt outstanding of $40 million.
Acme plans to maintain this same debt-equity ratio in the future. The firm pays an interest rate
of 7.5% on its debt and has a corporate tax rate of 35%.

MVE 100 a. If Acme’s free cash flow is expected to be $7 million next year and is expected to grow at a
MVD 40 rate of 3% per year, what is Acme’s WACC?
interest 7.50% FCF 7 MVF = FCF /(Wacc-g)
Tc 35.00% growth 3%
wacc ??? 140=7/(wacc-0,03)
MVF 140 wacc=0,03+7/140
8.00% pretaxwacc Wacc + D/V+D*rd*tc
8.75%
b. What is the value of Acme’s interest tax shield?

Vu = FCF/(pretaxwacc-g) 121.74

15-16. Milton Industries expects free cash flow of $5 million each year. Milton’s corporate tax rate is
35%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $19.05
million, and it expects to maintain this level of debt permanently.
FCF 5 a. What is the value of Milton Industries without leverage?
Tc 35% MVF = FCF/wacc
pretaxwacc 15% 33.33333
Debt 19.05 b. What is the value of Milton Industries with leverage?
VL=VU+Tc.D
40.00083

15-17. Suppose Microsoft has 8.75 billion shares outstanding and pays a marginal corporate tax rate of
35%. If Microsoft announces that it will payout $50 billion in cash to investors through a
combination of a special dividend and a share repurchase, and if investors had previously
assumed Microsoft would retain this excess cash permanently, by how much will Microsoft’s
share price change upon the announcement?
Tc 35% reducing cash is equivalent to leverage so payout with cash is the same of issuing debt
Shares 8.75 PVTS = Tc*Debt 17.5
Price = Number of Shares/MVE 2.0000 increase in 2 dolars
cted to grow at a

ame of issuing debt

15-18. Kurz Manufacturing is currently an all-equity firm with 20 million shares outstanding and a
stock price of $7.50 per share. Although investors currently expect Kurz to remain an all-equity
firm, Kurz plans to announce that it will borrow $50 million and use the funds to repurchase
shares. Kurz will pay interest only on this debt, and it has no further plans to increase or
decrease the amount of debt. Kurz is subject to a 40% corporate tax rate.

all equity Time zero Time one - after annoucement issuin

shares 20 assets 150 equity 150 assets 150
stockprice 7.5 cash 0 debt 0 cash 0
MVE 150 150 PVTS 20
tc 40% Shares 20
Price of sh 7.5

Time one - after issuing Time one - after repurchase

assets 150 equity 170 assets 150
cash 50 debt 50 cash 0
PVTS 20 220 PVTS 20
Shares 20
Price of sh 8.5
Shares to repurchase
Debt/Priceshares
Shares remaining

15-19. Rally, Inc., is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding.
Rally plans to borrow $10 billion and use these funds to repurchase shares. The firm’s corporate
tax rate is 35%, and Rally plans to keep its outstanding debt equal to $10 billion permanently.

all equity Time zero Time one - after annoucement issuin

assets 25 assets 25 equity 25 assets 150
shares 10 cash 0 debt 0 cash 0
price of sh 25 25 PVTS 3.5
tc 35% Shares 10
Price of sh 2.5

Time one - after issuing Time one - after repurchase

assets 25 equity 28.5 assets 25
cash 10 debt 10 cash 0
PVTS 3.5 38.5 PVTS 3.5
Shares 10
Price of sh 2.85
Shares to repurchase
Debt/Priceshares
Shares remaining
- after annoucement issuing debt
equity 170
debt 0
170
Shares 20
Price of share 8.5

- after repurchase
equity 120
debt 50
170
Shares 14.11765
Price of share 8.5

5.8823529412
14.117647059

- after annoucement issuing debt

equity 28.5
debt 0
28.5
Shares 10
Price of share 2.85

- after repurchase
equity 18.5
debt 10
28.5
Shares 6.491228
Price of share 2.85

3.5087719298
6.4912280702
15-26. Colt Systems will have EBIT this coming year of $15 million. It will also spend $6 million on total
capital expenditures and increases in net working capital, and have $3 million in depreciation
expenses. Colt is currently an all-equity firm with a corporate tax rate of 35% and a cost of
capital of 10%
a. If Colt is expected to grow by 8.5% per year, what is the market value of its
Assumptions g=8,5%
EBIT 15 MVF=FCF/(Wacc.g)
Capex 6 solve to FCF solve to wacc
Deprec 3 EBIT 15 all equity Wacc=10%
tc 35% EBIT(1-t) 9.75 re=10%
re 10% Deprec 3
Capex 6 MVF=6,75/(10%-8,5%)
FCF 6.75 MVF 450

b. If the interest rate on its debt is 8%, how much can Colt borrow now and sti
nonnegative net income this coming year?

Interest expense =EBIT Debt =Interest expense/interest rate

at is the market value of its equity today?

Wacc=10%

can Colt borrow now and still have

se/interest rate