Luther Industries is considering borrowing $500 million to fund a new product line.Given investors' uncertainty regarding its prospects,Luther will pay a 7% interest rate on this loan.The firm's management knows that the actual risk of the loan is extremely low and that the appropriate rate on the loan is 5%.Suppose the loan is for four years,with all principal being repaid in the fourth year.If Luther's marginal corporate tax rate is 35%,then the net effect of the loan on the value of the new product line is closest to:

Question

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D) Luther Industries is paying (7% - 5% = 2%) more for the loan than the risk demands. However, part of this 2% premium in the interest rate is being offset by the interest tax shield. Therefore the true cost in any year is the amount of debt × (2%) × (1 - τ_c). Cost per year = $500M(.02)(.65) = $6.5M, we need to discount this amount each year by the correct r_D of 5%, this is amount is constant and occurs each year for four years we have an annuity, solving: PMT = 6.5 I = 5% FV = 0 N = 4 Compute PV = $23.04 million

Luther Industries Is Considering Borrowing $500 Million to Fund a New