Manitoba Flat Land (MFL)Company has a perpetual EBIT of $10,000, an unlevered cost of equity of 5%, zero debt, and an income tax rate of 40%.The firm currently has 1,000 shares outstanding.MFL issues $5,000 of perpetual debt which pays interest of $500 per year and uses the proceeds of that debt issue to repurchase shares.The change in the value of the firm is:

Question

Quizplus · Accepted Answer

The change in the value of the firm is due to the tax shield from the interest on the debt. The tax shield is calculated as the interest payment ($500) multiplied by the tax rate (40%), which equals $200. Since this is a perpetual debt, the present value of the tax shield is $200 / 0.05 = $4,000. However, the question asks for the change in value, which is the present value of the tax shield minus the cost of debt, resulting in an increase of $2,000.

Manitoba Flat Land (MFL)Company Has a Perpetual EBIT of $10,000