Question

. a) Vita plc has currently no debt in its capital structure, and it is valued at £250 million. The return on the unlevered equity is 15%. The company has decided to modify its capital structure to enjoy the tax benefits of debt, by issuing £50 million of perpetual debt and using the proceeds to repurchase equity. The company has been told that any borrowings made by them will attract a rate of 7%. The tax rate is 35%.

i) What are the firm’s earnings before interest and taxes? (Assume that earnings are cash flows.) (5 marks)

ii) What is the return on equity after the change in the firm’s capital structure? (7 marks)

iii) Now assume that there is personal tax on interest income and equity distribution. The personal tax rate on interest income is 40%. What would the personal tax rate on equity distribution have to be to make the tax advantage of debt equal to zero? (7 marks)

AND b) “The shareholders of a levered firm will never want the firm to invest in a negative net present value project.” Do you agree or disagree with this statement? Explain. (7 marks)

Answer 1

a) i) The method to find out EBIT has been explained herein below:

Value of Firm= £ 250 million

Return of Unlevered equity= 15%

Since the firm has unlevered equity, it means that there is no debt. When there is no debt, then, Return on equity is equal to Cost of Firm., meaning thereby, that K_e= K_o.

Since Value of Firm = EBIT/K_o

So, EBIT= Value of Firm*K_o

EBIT= £250 million * 15/100

Hence, EBIT = £37.50 million.

a) ii) The method to find out of Cost of Equity is as follows:

Given: Debt= £50 million; Rate of Interest = 7%; Tax rate= 35%

K_d = Rate of Interest (1-Tax Rate)

K_d = 7% (1-0.35)

K_d = 4.55%

EBIT = £37.50 million

Interest = £37.50million*4.55%

Interest = £1.70 million

Net Profit= EBIT –Interest

Net Profit= £37.50-£1.70

Net Profit= £35.80 million

Ke= (EBIT-Interest)/Value of Firm- Value of Debt

Ke= £35.80million/£200 million

Hence, Ke= 17.90%

a) iii) The method to find out personal tax rate on equity income is as follows:

r*= 1- (1-r_c)(1-r_e)/(1-r_i)

r*= effective tax advantage of debt

r_c= Tax rate on corporate income

r_e= Tax rate on personal equity income

r_i= tax rate on personal interest income

r*= zero

r_e= ?

0 = 1- (1-.035)(1- r_e)/(1-0.40)

0= 1- 0.65-0.65r_e/0.60

0.65r_e= 0.05

r_e= 0.05/0.65

Hence, r_e= 7.69%

b) The answer to it as follows:

No, the statement is not correct,If a firm has debt, it might be advantageous to stockholders for the firm to undertake risky projects, even those with negative net present values. As most of the risk of failure is borne by banks/bondholders.