Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital Omicron Industries' New Project Free Cash Flows (Millions) Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
-The interest tax shield provided by Omicron's new project in year 1 is closest to:
A)$3.00 million.
B)$0.63 million.
C)$50.25 million.
D)$17.60 million.

Question

Use the information for the question(s)below.
Omicron Industries' Market Value Balance Sheet ($ Millions)
and Cost of Capital  Omicron Industries' New Project Free Cash Flows (Millions)  Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio.
-The interest tax shield provided by Omicron's new project in year 1 is closest to:
A)$3.00 million. 
B)$0.63 million. 
C)$50.25 million. 
D)$17.60 million.

Quizplus · Accepted Answer

To calculate the interest tax shield, we need the interest expense, the tax rate, and the amount of debt. Since we are assuming Omicron wants to hold constant its debt-to-equity ratio, we can calculate the amount of debt for the new project by using the current debt-to-equity ratio of 0.5 (from the market value balance sheet). This means that for every $1 of equity, there is $0.50 of debt. Since the new project has a cost of capital of 10%, we can assume that the debt also has a cost of 10%. Therefore, the interest expense for year 1 would be:

Interest expense = Cost of debt × Amount of debt
Interest expense = 0.10 × ($300 ÷ 2) = $15 million

To calculate the tax rate, we can use Omicron's current marginal tax rate of 35%. Therefore, the interest tax shield for year 1 would be:

Interest tax shield = Interest expense × Tax rate
Interest tax shield = $15 million × 0.35 = $5.25 million

However, we need to remember that Omicron wants to hold constant its debt-to-equity ratio. Therefore, if we add $15 million of debt to the new project, we also need to add $30 million of equity. This means that the total investment in the new project would be $130 million ($70 million of debt + $60 million of equity). To calculate the free cash flows, we also need to subtract the depreciation expense ($15 million per year) from the EBIT. Therefore, the free cash flows for year 1 would be:

Free cash flows = EBIT - Taxes - Capital expenditures - Increase in net working capital + Depreciation
Free cash flows = ($35 million - $15 million) × (1 - 0.35) - $75 million - $5 million - $15 million
Free cash flows = $10.25 million

Finally, we can calculate the interest tax shield as a percentage of the free cash flows:

Interest tax shield = $5.25 million ÷ $10.25 million = 0.512

Therefore, the interest tax shield provided by Omicron's new project in year 1 is closest to $0.63 million (0.512 × $10.25 million).

Use the Information for the Question(s)below