Note:

This topic has more questions than can be covered in a 2 hour session. The questions to be covered by your tutor are indicated by an asterisk (*); the rest should be viewed as extra practice problems.

15-1.    Pelamed Pharmaceuticals has EBIT of $133 million in 2006. In addition, Pelamed has interest

expenses of $49 million and a corporate tax rate of 35%.

a.   What is Pelamed’s 2006 net income (net income after tax)?

b.   What is the total of Pelamed’s 2006 net income and interest payments?

c.   If Pelamed had no interest expenses, what would its 2006 net income be? How does it compare to your answer in part b?

d.   What is the amount of Pelamed’s interest tax shield in 2006?

15-3*.   Suppose the corporate tax rate is 30%. Consider a firm that has a pretax cash flow (EBIT) of $1000 each year. Assume that this cash flow is risk-free and perpetual and that the firm has no other free cash flows. The risk-free interest rate is 8%.

a.    Suppose the firm has no debt. What is the value of the unlevered firm?

b.   Suppose that the firm has debt and makes interest payments of $700 per year at the risk- free rate. What is the value of the levered firm? What is the value of the levered equity? What is the value of debt?

c.   What is the difference between the total value of the firm in (a) and (b) and where does it come from?

15-5.    Your firm currently has $116 million in debt outstanding with an 8% interest rate. The terms

of the loan require it to repay $29 million of the balance each year until it has no debt. Suppose that the marginal corporate tax rate is 30%, and that the interest tax shields have the same risk as the loan. What is the present value of the interest tax shields from this debt?

15-10.  Rogot Instruments makes fine violins and cellos. It has $1.3 million in debt outstanding, equity valued at $2.7 million, and pays corporate income tax at rate of 33%. Its cost of equity is 12% and its cost of debt is 6%.

a.   What is Rogot’s pretax WACC?

b.   What is Rogot’s (effective after-tax) WACC?

16-12.  Hawar International is a shipping firm with a current share price of $6 and 15 million shares outstanding. Suppose Hawar announces plans to lower its corporate taxes by borrowing $10 million and repurchasing shares.

a.   With perfect capital markets, what will the share price be right after this announcement?

Suppose that Hawar pays a corporate tax rate of 40%, and that shareholders expect the change in debt to be permanent.

b.   If the only imperfection is corporate taxes, what will the share price be right after this announcement? Is it lower or higher than the original share price? What is the amount of the capital gain/loss and where does it come from?

c.    Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $6.25 right after this announcement, what is the PV of financial distress costs Hawar will incur as the result of this new debt?

Additional questions

Question 1.

Jackson Trucking Company is in the process of setting its target capital structure. The firm has 50 million shares outstanding. The CFO believes the optimal debt ratio is somewhere between 20 and 50 percent, and her staff has compiled the following projections for the stock price at various debt levels:

Assuming that the firm uses only debt and common equity, according to the trade-off theory of capital structure, what is Jackson’s optimal capital structure? At what debt ratio is the company’s WACC minimized?

Question 2*.

Assume that the Munch Company operates in a perfect capital market, with one exception being that companies pay tax at the rate of 30%. Each year, Munch generates EBIT or the pretax cash flow of $1,000,000 - which is expected in perpetuity. The firm will use this cash flow to pay interest to debtholders, tax to the government, and keep the balance as the income available to equity holders.

In each of the following cases a), b), c), calculate (i) the total interest paid on debt, (ii) the tax payment, (iii) the income available to equity holders, and (iv) the total income available to all Munch's investors.

a)          Assume Munch is unlevered.

b)         Now assume Munch is  slightly levered.   The cost  of debt  (rd ) is 10% p.a. and the annual interest payments on its debt amount to $100,000.

c)          Now assume Munch has substantially more debt in its capital structure. The cost of debt is still 10% p.a., but annual interest payments on the debt amount to $400,000.

d)         Do you think the following statement is correct? “The series of calculations above show two things: (i) as the level of debt increases, Munch pays less tax, and (ii) as the level of debt increases, the total income available all investors increases.”

Question 3*.

Assume the same information as Question 2. When the Munch Company is unlevered, its weighted- average cost of capital RU is 15% p.a.

a.   For cases a), b), and c) above, calculate (i) the cost of equity (Re), and (ii) the cost of capital (RWACC).

b.   Do you think the following statement is correct? “These calculations show that, in a world with corporate taxes, (x) the RWACC decreases as the proportion of debt increases, and (y) the cost of equity increases as the proportion of debt increases, but part of this increases is offset by the tax benefit of debt.”

Question 4*

Carnegie Enterprises is currently financed entirely by equity. There are  1 million shares on issue. Assume that Carnegie generates before tax cash flows (EBIT) of $400,000 each year and the corporate tax rate is 30%.

a)          Assuming that the required return on the unlevered equity is  10%. The annual net income is the free cash flow (income) available to equity investors, and this stream is in perpetuity. What is the total value of the firm? Equivalently, what is the market price for Carnegie shares?

Recalling her days as a student enrolling in a corporate finance course, Carnegie's manager remembers the MM theory with the tax advantage of debt. Although she never properly understood it at the time, she recalls that issuing some debt creates a tax advantage that somehow increases the net worth of shareholders. Being a major shareholder in Carnegie, she decides to give it a go.

Carnegie raises $200,000 by issuing (i.e., selling) perpetual bonds with the cost of debt being 6% p.a. The entire $200,000 is used for a leverage recapitalization plan where the firm will repurchase its shares to reduce its equity.

b)          Complete the following schedule for annual after-tax cash flows:

EBIT

Interest payment

Taxable income

Tax payment

Net Income

Compare how much tax Carnegie pays per annum now that it is levered with how much tax was paid in a).  What is the present value in perpetuity of this tax savings?