6. Fortune Enterprises is an all-equity firm that is considering issuing $13.5 million of perpetual debt. The interest rate is 10%. The firm will use the proceeds of the bond sale to repurchase equity. Fortune distributes all earnings available to stockholders immediately as dividends. The firm will generate $3 million of earnings before interest and taxes (EBIT) every year into perpetuity. Fortune is subject to a corporate tax rate of 40%. Suppose the personal tax rate on interest income is 55%, and the personal tax rate on equity income is 20%.
a. What is the annual after-tax cash flow to equity holders under each plan? (3 points)
Answer :
a)
| Particulars | Unlevered plan | Levered plan |
| EBIT | $3 million | $3 million |
| Less : Interest [ $13.5 m * 10% ] | Nil | $1.35 million |
| EBT | $3 million | $1.65 million |
| Less : Tax @ 40% | $1.2 million | $0.66 million |
| Net profit distributed as dividends | $1.8 million | $0.99 million |
| Less : Tax @ 20% | $0.36 million | $0.198 million |
| Equity holders amount | $1.44 million | $0.792 million |
Equity holders get $1.44 million under the unlevered plan and $0.792 million under levered plan.
Get Answers For Free
Most questions answered within 1 hours.