Suppose the corporate tax rate is 35%. Consider a firm that earns $3,000 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 4%.
a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value ofthe firm's equity?
b. Suppose instead the firm makes interest payments of $1,300 per year. What is the value of equity? What is the value of debt?
c. What is the difference between the total value of the firm with leverage and without leverage?
d. The difference in (c) is equal to what percentage of the value of the debt?