Question

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%.

1) What is the annual after-tax cash flow to equity holders under each plan?

2) What is the annual after-tax 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

Answer 1

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(1-0.2) = 1.44

Case 2: 0.99(1-0.2) = 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 (1-0.55) = 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.

answered by: anonymous