Question

Samsung currently has no debt and a cost of equity of 25%. They are thinking about issuing debt to buy back some of their equity. In particular, they are thinking about issuing $100 in debt with a coupon rate and yield-to-maturity of 5%. Further, their plan is to keep their debt level constant at $100 over time forever, no matter how well the firm does. How much would the value of Samsung increase if they follow through with this plan, and their tax rate is 40%?

a. $10

b. $20

c. $30

d. $40

Answer 1

Samsung's value would increase by $40 (option d), which is the perpetuity value of the annual tax shield benefit obtained by issuing $100 in debt at a 5% interest rate and a 40% tax rate.

Step-by-step explanation:

To determine how much the value of Samsung would increase by issuing debt to repurchase equity, we need to consider the tax shield benefit of the debt. Samsung is planning to issue $100 in debt at a 5% interest rate. With a tax rate of 40%, the annual tax shield is the interest expense multiplied by the tax rate. Therefore, the annual tax shield is ($100 * 5%) * 40% = $2 per year.

Since the firm plans to maintain this debt level forever, we can treat this as a perpetuity. The value of the tax shield is calculated as the annual tax shield divided by the cost of debt. As the cost of debt is equal to the yield to maturity, which is also 5%, we use the same rate to calculate the perpetuity value.

The value of the tax shield as a perpetuity is $2 / 0.05 = $40. Hence, the increase in the value of Samsung due to the tax shield benefit would be $40. This increase in value is due solely to the tax advantages of the interest payments.