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:
A)$22 million
B)$34 million
C)$35 million
D)$24 million

Question

Quizplus · Accepted Answer

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