Two firms, No Leverage, Inc., and High Leverage, Inc.

, have equal levels of operating

risk and diff er only in their capital structure. No Leverage is unlevered and High
Leverage has $500,000 of perpetual debt in its capital structure. Assume that the
perpetual annual income of both firms available for stockholders is paid out as dividends.
Hence, the growth rate for both fi rms is zero. Th e income tax rate for both firms is 40
percent. Assume that there are no financial distress costs or agency costs. Given the
following data: No Leverage, Inc. High Leverage, Inc. Equity in capital structure Cost of
equity, ke Debt in capital structure Pretax cost of debt, kd Net operating income (EBIT)
$1,000,000 10% — — $ 100,000 $500,000 13% $500,000 7% $100,000 determine the a.
Market value of No Leverage, Inc. b. Market value of High Leverage, Inc. c. Present
value of the tax shield to High Leverage, Inc.

a. No Leverage, Inc. High Leverage, Inc.

Net operating income (EBIT) $100,000 $100,000

Less: interest payments (I) --- $35,000

Earnings before taxes $100,000 $65,000

Income taxes (40%) 40,000 26,000

Income available to

stockholders (D) $60,000 $39,000

Total income available to

security holders (I + D) $60,000 $74,000

Market value (No Leverage) = $60,000/0.10 = $600,000

b. Market value (High Leverage) = $39,000/0.13 + $35,000/0.07

= $800,000

c. Present value (tax shield) = $500,000 x 0.40 = $200,000