Question 16.S-TP.3: M&M Proposition I (with corporate taxes) Gypco expects a...
M&M Proposition I (with corporate taxes) Gypco expects an EBIT of $10,000 every year forever. Gypco can borrow at 7 percent. Suppose Gypco currently has no debt, and its cost of equity is 17 percent. If the corporate tax rate is 21 percent, what is the value of the firm? What will the value be if Gypco borrows $15,000 and uses the proceeds to repurchase stock?
With no debt, Gypco’s WACC is 17 percent. This is also the unlevered cost of capital. The aftertax cash flow is $10,000 × (1 − .21) = $7,900, so the value is just V_{U} = $7,900/.17 = $46,471.
After the debt issue, Gypco will be worth the original $46,471 plus the present value of the tax shield. According to M&M Proposition I with taxes, the present value of the tax shield is T_{C} × D, or .21 × $15,000 = $3,150; so the firm is worth $46,471 + 3,150 = $49,621.