Eastcoast Transport Ltd can borrow at 7.5 per cent.The firm currently has no debt,and the cost of equity is 16 per cent.The current value of the firm is $540 000.What will the value be if the firm borrows $160 000 and uses the proceeds to repurchase shares? The corporate tax rate is 34 per cent.

Question

Quizplus · Accepted Answer

The value of the firm will increase by the tax shield on the debt. The tax shield is calculated as the debt amount multiplied by the tax rate: $160,000 * 0.34 = $54,400. Adding this to the current value of the firm gives $540,000 + $54,400 = $594,400.

Eastcoast Transport Ltd Can Borrow at 7