Problem: Here are book and market value balance sheets of the United Frypan Company (UF):
Book Market:
Net working capital $ 20 $ 40 Debt Net working capital $ 20 $ 40 Debt
Long- term assets 80 60 Equity Long- term assets 140 120 Equity
$ 100 $ 100 $ 160 $ 160
Assume that MM's theory holds with taxes. There is no growth, and the $ 40 of debt is expected to be permanent. Assume a 40% corporate tax rate.
1. How much of the firm's value is accounted for by the debt-generated tax shield?
2. How much better off will UF's shareholders be if the firm borrows $20 more and uses it to repurchase stock?