MM with and without Taxes

International Associates (IA) is about to commence operations as an international trading company. The firm will have book assets of $10 million, and it expects to earn a 20% return on these assets before taxes. However, because of certain tax arrangements with foreign governments, IA will not pay any taxes; that is, its tax rate will be zero. Management is trying to decide how to raise the required $10 million. It is known that the capitalization rate r_U for an all-equity firm in this business is 12%, and IA can borrow at a rate r_d = 6%. Assume that the MM assumptions apply.

A. According to MM, what will be the value of IA if it uses no debt? Do not round intermediate calculations. Round your answer to the nearest dollar. $____

If it uses $6 million of 6% debt? Do not round intermediate calculations. Round your answer to the nearest dollar. $____

B. What are the values of the WACC and r_s at debt levels of D = $0, D = $6 million, and D = $10 million? Do not round intermediate calculations. Round your answers to two decimal places.

D = $0 --> WACC = ___% rs = ____%

D = $6 million --> WACC = ___% rs = ____%

D = $10 million --> WACC = ___% rs = ____%

C. Assume the initial facts of the problem (r_d = 6%, EBIT = $2 million, r_sU = 12%), but now assume that a 40% federal-plus-state corporate tax rate exists. Use the MM formulas to find the new market values for IA with zero debt and with $6 million of debt. Do not round intermediate calculations and do not use rounded values from previous step in your calculations. Round your answers to the nearest dollar.

Zero debt: $____

$6 million of debt: $____

D. What are the values of the WACC and r_s at debt levels of D = $0, D = $6 million, and D = $10 million, if we assume a 40% corporate tax rate? Do not round intermediate calculations. Round your answers to two decimal places. On a separate piece of paper plot the relationship between the value of the firm and the debt ratio as well as that between capital costs and the debt ratio.

D = $0 --> WACC = ___% rs = ____%

D = $6 million --> WACC = ___% rs = ____%

D = $10 million --> WACC = ___% rs = ____%

E. What is the maximum dollar amount of debt financing that can be used? Do not round intermediate calculations. Round your answer to the nearest dollar. $____

What is the value of the firm at this debt level? Do not round intermediate calculations. Round your answer to the nearest dollar. $____

What is the cost of this debt? Round your answer to two decimal places. ____%