A company has two asset positions: (i) Euro 100 million in liquid assets invested in the money market at a risk-free interest rate and (ii) risky assets that are expected to generate a sustainable annual cash flow of Euro 30 million (but never less than Euro 10 million).
The company has permanent debt capital, which leads to sustained interest payments of Euro 30 million. Cash flows generated that are not used for interest payments on borrowed capital are distributed in full to the equity investors as dividends.
The risk-free interest rate is 2% p.a., and the risk premium for the risky assets is 2% p.a.. The company calculates with an income tax rate of 25% (other taxes are not to be taken into account). Apart from the above assumptions, assume perfect capital markets.
(a) What is the market value of the risky assets (without taking taxes into account)?
(b) What is the market value of debt?
(c) What is the market value of the indebted total enterprise?
(D) What is the market value of the equity of the indebted enterprise?
(e) What is the market value of the tax saving due to the deductibility of interest on debt (tax shield) ?