1. ABC Inc., a manufacturing firm with no debt outstanding and a market value of $100 million is considering borrowing $ 40 million and buying back stock. Assuming that the interest rate on the debt is 9% and that the firm faces a tax rate of 35%, answer the following questions: a. Estimate the annual interest tax savings each year from the debt. b. Estimate the present value of interest tax savings, assuming that the debt change is permanent. c. Estimate the present value of interest tax savings, assuming that the debt will be taken on for 10 years only. d. What will happen to the present value of interest tax savings, if interest rates drop tomorrow to 7% but the debt itself is fixed rate debt?
Answer 1: a. Annual tax savings from debt = $ 40 million * .09 * .35 = $ 1.26 b. PV of Savings assuming savings are permanent = $ 40 million * .35 = $ 14.00 c. PV of Savings assuming savings occur for 10 years = $ 1.26 (PVA,9%,10) = $ 8.09 d. PV of Savings will increase If savings are permanent = 1.26/.07 = $ 18.00 If savings are for 10 years = $1.26 (PVA,7%,10) = $ 8.85
1. XYZ Corporation, a manufacturer of consumer plastic products, is evaluating its capital structure. The balance sheet of the company is as follows (in millions): Assets Fixed Assets 4000 Current Assets 1000 Liabilities Debt 2500 Equity 2500 In addition, you are provided the following information: (a) The debt is in the form of long term bonds, with a coupon rate of 10%. The bonds are currently rated AA and are selling at a yield of 12% (the market value of the bonds is 80% of the face value). (b) The firm currently has 50 million shares outstanding, and the current market price is $80 per share. The firm pays a dividend of $4 per share and has a price/earnings ratio of 10. (c) The stock currently has a beta of 1.2. The six-month Treasury bill rate is 8%. (d) The tax rate for this firm is 40%. I. What is the debt/equity ratio for this firm in book value terms? in market value terms? II. What is the debt/(debt+equity) ratio for this firm in book value terms? in market value terms? III. What is the firm's after-tax cost of debt? IV. What is the firm's cost of equity? V. What is the firm's current cost of capital?
(1) Book Value Debt/Equity Ratio = 2500/2500 = 100% Market Value of Equity = 50 million * $ 80 = $4,000 Market Value of Debt = .80 * 2500 = $2,000 Debt/Equity Ratio in market value terms = 2000/4000 = 50.00% (2) Book Value Debt/(Debt+ Equity) = 2500/(2500 + 2500) = 50% Market Value Debt/(Debt+Equity) = 2000/(2000+4000) = 33.33% (3) After-tax Cost of Debt = 12% (1-0.4) = 7.20% (4) Cost of Equity = 8% + 1.2 (5.5%) = 14.60% (5) Cost of Capital = 14.60% (4000/6000) + 7.20% (2000/6000) = 12.13%
Explain the difference between Opportunity Cost and Sunk Cost?
Opportunity cost is essentially the cost of forgone investment. If a firm chooses one alternative over the other, the cost of choosing that alternative/project is the opportunity cost for the firm. For ex. A company can either use its cash to invest in Govt. securities and earn 2% p.a. or invest in a factory and earn an IRR of 15%. Here the opportunity cost of choosing the factory project is 2% since company will forgo this 2% income to invest that cash in the factory. Sunk cost on the other hand is the cost that a firm incurs and cannot be recovered irrespective of the subsequent investment decision. Sunk costs should not be considered while making investment decisions since these costs can never be recovered. For ex. R&D costs are sunk costs for the company.