Question

Wigdor Manufacturing is currently all equity financed, has EBIT of $2 million, and is in the 34% tax bracket. Louis, the company's founder, is the lone shareholder. 26. If the firm were to convert $4 million of equity into debt at a cost of 10%, what would be the total cash flow to Louis if he holds all the debt? Compare this to Louis' total cash flow if the firm remains unlevered. Assume no personal taxes. 27. Assume that all earnings are paid out as dividends. Now consider the fact that Louis must pay personal tax on the firm's cash flow. Louis pays taxes on interest at a rate of 33%, but pays taxes on dividends at a rate of 28%. Calculate the total cash flow to Louis after he pays personal taxes.

Answer 1

Wigdor Manufacturing

Given information:

EBIT (Earnings before Interest and Taxes) - $2.0 million

Tax rate: 34%

Equity to debt conversion: $4.0 million

Cost of debt: 10%

Louis shareholding: 100% of Wigdor Manufacturing

Question 1:

Total cash flow to Louis’ if he holds all the debt:

Answer:

Interest paid on debt: $4.0 million X 10% (interest cost)

= $0.4 million

$ million	Amount
EBIT	4.0
Interest	0.4
EBT	3.6
Taxes	1.2
Net earnings	2.4
Louis cashflow
Net earnings from Wigdor (100% dividends)	2.4
Interest received from Wigdor	0.4
Total cashflow to Louis	2.8
* assuming no personal taxes

Question 2:

Calculate total cashflow to Louis if he pays personal taxes

Given information:

Taxes on dividends: 28%

Taxes on interest: 33%

	Louis cashflow after personal taxes
	$ million	Amount
1	Net earnings from Wigdor (100% dividends)	2.40
2	Personal taxes on dividends @ 28%	0.67
A (1-2)	Net cashflow from dividends	1.73
3	Interest received from Wigdor	0.40
4	Personal taxes on interest @33%	0.13
B (3-4)	Net cashflow from interest	0.27
C (A+B)	Total cashflow to Louis	2.00