Question

Domina Co considering raising some new finance but there is disagreement at the Board level how best to proceed.

The managing director thinks that the company should retain control in the hands of existing and loyal shareholders. The finance director feels that the gearing level should be allowed to increase to benefit from the tax relief allowed on interest.

The existing equity is quoted at 4.20 € with dividend with an imminent dividend of 0.16 € due any day. The company earnings have grown at a fairly steady rate of 8% over recent years, but expectations are for growth to be 2% points better in the future.

The company's debt is 4% irredeemable bonds, which were issued at a 5% discount of 95 €. They have a nominal value of 100 € but are currently quoted at 80 € the interest having just paid. The corporation tax rate is 25%.

b) Assuming the business wants to maximise the tax shield on the new finance, how should it raise the money?

Select one:

a. A placing of new shares and 10,000,000 € of preference shares

b. Accepting a venture capital offer which includes 5,000,000 € of 4% redeemable bonds and some shares

c. Sell redeemable debt with market value 12,500,000 € with interest at 5%. The redemption value will make up 25% of the market value

d. Sell 12,000,000 irredeemable debt with interest at 5.25%

Answer 1

d.Sell 12,000,000 irredeemable debt with interest at 5.25%.

,because tax shield is more in this case(d) compare to c.Sell redeemable debt with market value 12,500,000 € with interest at 5%. The redemption value will make up 25% of the market value12,50. show below computation

Tax shield in case of option d = 12,000,000 €*5.25%*25% = 157,500 €

Tax shield in case of option c = 12,500,000 €*5%*25% = 156,250 €

Conclusion: tax benefit more in case of option d

Formula; Tax shield = Interest *corporate tax rate

it is obviously option a and option b will not give tax benefit more than debt, because it includes shares.