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Wartsila BV is levered. It has a perpetual outstanding debt, with a yearly interest payment

of $30000. The cost of debt is the risk-free rate of 5%. The EBIT of the corporation is

$60000 and expected to be constant forever. The corporate tax rate is 35%. Interest

payments are tax-deductible, but only up to 30% of the EBIT. This morning, unexpectedly,

the government has changed the tax regime. Now, interest payments are tax-deductible

up to 55% of the EBIT, while the marginal corporate tax rate stays the same. Based on this

change in the tax-regime, what is the total increase in the value of equity in the firm upon

the announcement of the change in the tax regime?

Answer :

Final answer:

The total increase in the value of equity in the firm upon the announcement of the change in the tax regime is $300000.

Explanation:

To calculate the total increase in the value of equity in the firm upon the announcement of the change in the tax regime, we need to compare the value of equity before and after the change.

Before the change, the interest payments were tax-deductible up to 30% of the EBIT. This means that the tax shield provided by the interest payments was limited to 30% of the EBIT.

After the change, the interest payments are now tax-deductible up to 55% of the EBIT. This means that the tax shield provided by the interest payments has increased.

To calculate the increase in the tax shield, we can subtract the old tax shield from the new tax shield:

New Tax Shield = 55% of EBIT - 30% of EBIT

New Tax Shield = 25% of EBIT

Now, we can calculate the increase in the value of equity using the formula:

Increase in Value of Equity = Increase in Tax Shield / Cost of Debt

Cost of Debt = 5% (given)

Let's substitute the values:

Increase in Value of Equity = (25% of EBIT) / 5%

Since the EBIT is $60000, we can calculate:

Increase in Value of Equity = (25% * $60000) / 5%

Increase in Value of Equity = $15000 / 0.05

Increase in Value of Equity = $300000

Therefore, the total increase in the value of equity in the firm upon the announcement of the change in the tax regime is $300000.

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