Question

is considering issuing $10,000,000 worth of perpetual bonds yielding $600,000 interest per year. ABC currently has no debt outstanding and will use the bond proceeds to repurchase equity. ABC has 100% dividend payout ratio and EBIT is $2,000,000 per year forever. Corporate tax rate is 30%.

If the personal tax rate is 28%, which plan (all equity or debt + equity) offers the investors the highest cash flows? Why?
If the shareholders require a 15% return before personal taxes, what is the value of the firm under each plan? (Do not ignore personal taxes).

Answer 1

Answer 1:

	Firm If Equity Financed	Firm If Debt Financed
EBIT	2000000	2000000
Interest	0	600000
PBT	2000000	1400000
tax@30%	600000	420000
PAT	1400000	980000
Personal Tax@28%	392000	274400
Net Cash Flow	1008000	705600

In the given question, Firm with whole equity financed will experience more cash flows as compared to the firm which is debt financed, as the income of shareholders are reduced due to the interest burden in the debt financed company.

Answer 2

	Firm If Equity Financed	Firm If Debt Financed
Equity	9,333,333.333	6,533,333.333
Debt	0	10,000,000
Total Value	9,333,333.333	16,533,333.33