AcF 214 Tutorial Week 9. Question 15.22 Markum Enterprises is considering permanently adding $100 million of debt to its capital structure. Markum’s corporate.

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Presentation transcript:

AcF 214 Tutorial Week 9

Question Markum Enterprises is considering permanently adding $100 million of debt to its capital structure. Markum’s corporate tax rate is 35%. a.Absent personal taxes, what is the value of the interest tax shield from the new debt? b.If investors pay a tax rate of 40% on interest income, and a tax rate of 20% on income from dividends and capital gains, what is the value of the interest tax shield from the new debt?

Question Add $100 million of debt; Tax rate is 35%; (a) Value of the interest tax shield from the new debt? PV = D = 35% × 100 = $35 million (b) Tax rate for interest income 40%; Tax rate for dividends and capital gains 20% Value of the interest tax shield from the new debt? PV = D = 13.33% 100 = $13.33 million

Question Suppose the tax rate on interest income is 35%, and the average tax rate on capital gains and dividend income is 10%. How high must the marginal corporate tax rate be for debt to offer a tax advantage?

Question Tax rate on interest income is 35%; Tax rate on capital gains and dividend income is10%; How much must the marginal corporate tax rate be for debt to off a tax advantage? if and only if i.e. Thus, there is a tax advantage of debt as long as the marginal corporate tax rate is above 27.8%.

Question Zymase is a biotechnology start-up firm. Researchers at Zymase must choose one of three different research strategies. The payoffs (after-tax) and their likelihood for each strategy are shown below. The risk of each project is diversifiable. a) Which project has the highest expected payoff? b) Suppose Zymase has debt of $40 million due at the time of the project’s payoff. Which project has the highest expected payoff for equity holders? c) Suppose Zymase has debt of $110 million due at the time of the project’s payoff. Which project has the highest expected payoff for equity holders? d) If management chooses the strategy that maximizes the payoff to equity holders, what is the expected agency cost to the firm from having $40 million in debt due? What is the expected agency cost to the firm from having $110 million in debt due?

Question Assume it is a limited liability company! (a) Which project has the highest expected payoff? E(A) = $75 million E(B) = 0.5 × 140 = $70 million E(C) = 0.1 × × 40 = $66 million Project A has the highest expected payoff. (b) Suppose with debt $40 million. Expected payoff for equityholders? E(A) = 75 – 40 = $35 million E(B) = 0.5 × (140 – 40) = $50 million E(C) = 0.1 × (300 –40) × (40 – 40) = $26 million Project B has the highest expected payoff for equity holders.

(c) Suppose with debt $110 million. Expected payoff for equityholders? E(A) =$0 million E(B) = 0.5 × (140 – 110) = $15 million E(C) = 0.1 × (300 –110) = $19 million Project C has the highest expected payoff for equity holders. (d) With $40 million in debt, management will choose project B, which has an expected payoff for the firm that is 75 – 70 = $5 million less than project A. Thus, the expected agency cost is $5 million. With $110 million in debt, management will choose project C, resulting in an expected agency cost of 75 – 66 = $9 million.

Question Which of the following industries have low optimal debt levels according to the trade-off theory? Which have high optimal levels of debt? a) Mature restaurant chains b) Pharmaceuticals c) Utilities d) Cell phone manufacturers e) Tobacco firms

Question a) Mature restaurant chains: high optimal debt level—stable cash flows, low growth, low distress costs b) Pharmaceuticals: low optimal debt level—high growth opportunities, high distress costs c) Utilities: high optimal debt level—stable cash flows, low growth, low distress costs d) Cell phone manufacturers: low optimal debt level—high growth opportunities, high distress costs e) Tobacco firms: high optimal debt level—high free cash flow, low growth opportunities

Question The HNH Corporation will pay a constant dividend of $2 per share, per year, in perpetuity. Assume all investors pay a 20% tax on dividends and that there is no capital gains tax. Suppose that other investments with equivalent risk to HNH stock offer an after-tax return of 12%. a) What is the price of a share of HNH stock? a) Assume that management makes a surprise announcement that HNH will no longer pay dividends but will use the cash to repurchase stock instead. What is the price of a share of HNH stock now?

Question Dividend $2 per share, per year, in perpetuity Tax rate on dividend 20% Cost of capital 12% (a) Price of the stock? P = $2*(1-0.2)/0.12 = $1.60/0.12 = $13.33 (b) No dividend, use cash to repurchase stock. Price of the stock? P = $2/0.12 = $16.67 Firm value derives from future free cash flow. Therefore, share repurchase equals to dividend $2 per share without tax.