Three company analysis of tax shield and debt
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Acme Storage has a market capitalization of $100 million and debt outstanding of $40 million. Acme plans to maintain this same debt-equity ratio in the future. The firm pays an interest rate of 7.5% on its debt and has a corporate tax rate of 35%.
A) If Acme's free cash flow is expected to be $7 million next year and is expected to grow at a rate of 3% per year, what s Acme's WACC?
B) What is the value of Acme's interest tax shield?
Suppose Tefco Corp. has a value of $100 million if it continues to operate, but has outstanding debt of $120 million that is now due. If the firm declares bankruptcy, bankruptcy cost will equal $20 million, and the remaining $80 million will go to creditors. Instead of declaring bankruptcy, management proposes to exchange the firm's debt for a fraction of its equity in a workout. What is the minimum fraction of the firm's equity that management would need to offer creditors for the workout to be successful?
Apple Computer has no debt. As problem 21 in Chapter 15 makes clear, by issuing debt Apple can generate a very large tax shield potentially worth over $10 billion. Given Apple's success, one would be hard pressed to argue that Apple's management are naive and unaware of this huge potential to create value. A more likely explanation is that issuing debt would entail other cost. What might these costs be?
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Solution Summary
A three company analysis of tax shield and debt is examined. The value of the Acme's interest tax shield is examined.
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