Here are book and market value balance sheets of the United Frypan Company (UF):

Market Net working capital $ 20 $ 40 Debt Long-term assets 140 120 Equity

$160 $160 Book Net working capital $ 20 $ 40 Debt Long-term assets 80 60 Equity

$100 $100 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.

a. How much of the firm’s value is accounted for by the debt-generated tax shield?

b. How much better off will UF’s shareholders be if the firm borrows $20 more and uses it to repurchase stock?

AppendixLO1