Fortune Enterprises is an allequity 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%.
1) What is the annual aftertax cash flow to equity holders under each plan?
2) What is the annual aftertax cash flow to debt holders under each plan?
3) Does debt still have an advantage over equity in this case, and why?
Unlevered 
Levered 

EBIT 
$3 million 
$3 million 
Interest 
$0 million 
$1.35 million =$13.5 m*0.1 
EBT 
$3 million 
$1.65 million 
Corporate Taxes 
$1.2 million 
$0.66 million 
Net Income 
$1.8 million 
$0.99 million 
1) Cash avalable to equity shareholders. Personal tax ie 20%
Hence , net cashflow with equity shall be Net Profit (1 Tax Rate)
Case 1: 1.8(10.2) = 1.44
Case 2: 0.99(10.2) = 0.792
2) Cash avalable to debt holders. Personal tax ie 55%
Hence , net cashflow with debt shall be Interest(1 Tax Rate)
Case 1: Nil
Case 2: 1.35 (10.55) = 0.6075
3) To find out whether debt is advantage over equity or not, we sum up the personal income in respecteive cases for equity shareholders and debt.
Total Case 1: 1.44
Total Case 2: 1.3995
Hence, we observe that personal income reduces from Case 1 to Case 2 , hence debt does not have an advantage over equity.
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