Pfizer is a large biotechnology company. Until now, Pfizer has been completely equity financed. Management feels that Pfizer is a maturing company with steady earnings, so they are considering adding debt to the capital structure. Specifically, Pfizer is considering issuing $10 billion in debt at 7% to finance share repurchases. Pfizer’s market capitalization is $100 billion. There is no risk of bankruptcy. The company’s marginal tax rate is 35%.
a. Estimate the annual tax savings from debt.
b. Assuming the company continues to have the same amount of debt forever, what is the present value of this tax shield?
c. According to tradeoff theory, what should the new value of the firm be? What is the value of the firm’s equity? How much would the firm’s current shareholders benefit by the move?