Question

ERP Corp. is considering financing a project with only equity. The project’s unlevered cost of capital (r_A) is 10%. The project will require a $1500 initial investment today and pay incremental free-cash-flows of $150 in perpetuity starting the one year from now. If the firm were to finance the project with debt so that its target D/E ratio is 0.50, What is the value of the interest tax-shield? Assume the interest rate on the new debt will be 3%, and the firm faces a 21% tax rate. Round your answer to two decimals.

Answer 1

To Solve this problem, firstly we need to know about the Interest Tax shield and how it is calculated.

Definition:The intention of it is to eliminate or remove the tax liability from our pocket. This can reduce the effective income tax rate of an individual or a business when their taxable income is high.

Calculation:

The following table will explain you the the total interest and Interest Tax Shield

				Given
Initial Investment	$ 1,500.00			Incremental Cash Flow	$     150.00
Present Value of Future cash outflows	$ 1,500.00			Kc	10%
Total Capital required	$ 3,000.00			D/E	0.5
				Int Rate	3%
				Tax Rate	21%
Debt		$ 1,500.00
Equity		$ 1,500.00
Interest Expense		$        45.00
Interest Tax Shield		$          9.45

Calculations:

1) In the above table the formula for calculating Present Value of Perpetuity is -. Here is PMT is periodic payment and "i" is discounting rate/unlevered cost of capital.

2) We can divide the debt and equity amount individually from the total amount and it is divided equally.

3)It is given that 3% is the interest rate for the debt i.e.$45.00

4) Therefor the Int tax shield will be ($ 45)*21% = $ 9.45