A firm is all equity with 5,000 shares outstanding worth $7 each.They are planning on issuing $10,000 of new perpetual debt at the 8% market rate of interest.The effective tax rate is 25%.What is the change in equity value if they make the debt for equity exchange?
A) $.50 per share
B) $200
C) $800
D) $.16 per share

Question

Quizplus · Accepted Answer

The correct answer is A. The change in equity value is $0.50 per share. This is because the firm is issuing $10,000 of new debt at an 8% interest rate. This will result in annual interest payments of $800. The firm is currently all equity, so the interest payments will be tax-deductible. This will save the firm $200 in taxes each year. The present value of these tax savings is $2,500. This is the amount by which the equity value of the firm will increase.

A Firm Is All Equity with 5,000 Shares Outstanding Worth