Suppose the corporate tax rate is 40%. Consider a firm that earns $1000 before interest and

taxes each year with no risk. The firms 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 5%.

a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is

the value of the firms equity?

b. Suppose instead the firm makes interest payments of $500 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 part (c) is equal to what percentage of the value of the debt?