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6. Fortune Enterprises is an all-equity firm that is considering issuing $13.5 million of perpetual debt....

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)

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Answer #1

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.

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