# HW 6 Fin 402 Solutions

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HW 6 Fin 402 Solutions
FINANCE 402 FALL 2014 HOMEWORK #6 Due November 20, 2014
1. BMA Chapter 18 – Questions 12 and 21 at the end of the chapter on pages 468-469.
Q12. Compute the present value of interest tax shields generated by these three debt issues Consider corporate taxes only. The marginal tax rate is 35%.
a. \$1000, one-year loan, at interest rate of 8%
(tax shield) = (tc x i x D) = (0.35 x 0.08 x \$1,000) = \$28
PV(tax shield) = \$28/(1+i)^1 = \$25.93
b. A five-year loan of \$1000 at 8% interest rate. No principal is repaid until maturity.
Tax Shield = tc x i x D = (0.35 x 0.08 x \$1,0000) = \$28
Year 1 = PV(tax shield) = \$28/(1+0.08)1 = \$25.93
Year 2 = PV(tax shield) = \$28/(1+0.08)2 = \$24.00
Year 3 = PV(tax shield) = \$28/(1+0.08)3 = \$22.23
Year 4 = PV(tax shield) = \$28/(1+0.08)4 = \$20.58
Year 5 = PV(tax shield) = \$28/(1+0.08)5 = \$19.06
PV(tax shield – 5 years) = \$111.80
c. A \$1000 perpetuity at an interest rate of 7%
PV(tax shield) = tc x D = (\$1000 x 0.35) = \$350.00
. “I was amazed to find that the announcement of a stock issuance drives down the value of the firm by 30%, on average, of the proceeds of the issue. That issue cost dwarfs the underwriter’s spread and the administrative costs of the issue. It makes common stock issues prohibitively expensive.”
a. You are contemplating a \$100 million stock issue. On past evidence, you anticipate that announcement of this issue will drive down stock price by 3% and that the market value of your firm will fall by 30% of the amount to be raised. On the other hand, additional equity financing is required to fund an investment project that you believe has a positive NPV of \$40 million. Should you proceed with the issue?

Yes, because we should always invest in a positive NPV project, which maximizes the value of the firm.

No. Under the Pecking Order, asymmetric information favors debt over equity issue since companies benefit from higher returns on equity and interest tax shields from debt. An advantage of issuing debt is

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