Question
Watson Cthulu Industries has 4 million shares of stock outstanding and pays out 100% of earnings in dividends. Earnings per share (EPS) is $3.50. The
Watson Cthulu Industries has 4 million shares of stock outstanding and pays out 100% of earnings in dividends. Earnings per share (EPS) is $3.50. The cost of equity is 13.5%. The firm pays interest of $3 million each year on bonds with an average coupon rate of 7.5%. Assume an income tax at a rate of 41%. For all parts of the problem below, enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1200000. Do not round intermediate calculations. Round the answer to two decimal places. 1. Calculate the value of the firm assuming there is no tax shield associated with debt (that is, assume interest is subtracted in calculating earnings, but is not deductible in calculating taxes). $ million 2. Compare it to the value calculated under the assumptions of Modigliani and Miller's simplest model (i.e., that there are no taxes and no transaction costs in financial markets). How much value has theoretically been lost to investors as a result of taxes? $ million 3. What is the value of the tax shield associated with the firm's debt? $ million 4. What is the benefit of debt (the present value of the annual tax shield in perpetuity discounted at the return on debt)? $ million 5. Calculate the theoretical value of the firm including the benefit of debt. $ million 6. Compare it with the value calculated under the assumptions of Modigliani and Miller's simplest model. The difference is $ million.
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