3. Assume that the expected earnings before interest and taxes (EBIT) is E(X)= X and so...

 

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3. Assume that the expected earnings before interest and taxes (EBIT) is E(X)= X and so the expected returns net of taxes of an unlevered firm is (1-1)X, where , represents the marginal corporate income tax rate. On the other hand, for an equal-size levered firm with the same EBIT and with a permanent level of debt D, in the capital structure and r being the rate of interest on the debt, the expected returns net of taxes will be X* =(1-c)(X -rD₂) +rD₂. Now consider that investors are subject to personal taxes and capital gain taxes. That is, a dollar of profit after tax will be subject to personal tax if paid out as dividend or capital gain tax if reinvested by the firm. Interest on debt is always subject to personal tax. Leto represent the dividend payout ratio and Tep, and represent rates of corporate tax, personal tax and capital gains respectively. Let * be the rate at which the market capitalizes the uncertain stream of returns and r be the rate at which the market capitalizes the sure streams generated by debts. Modigliani and Miller (1963) argued that annual tax saving from the use of debt should be capitalized at a lower rate and that r<p². Required: a) Show the after-tax returns to the stockholders of the unlevered fim. What will be the after-tax returns to stockholders and bondholders of the levered firm? b) What will be the values of the levered firm compared with that of the unlevered firm? c) Consider X = 1000, D₁ = 4000, r=0.05, p = 0.10, and T =.40. If personal taxes and capital gain taxes exist and T, (= 0.10) < (= 0.25), show the value of the levered firm compared with that of the unlevered firm when 0-0.00, 0.50, and 1.00. How does the capital structure change as the payout ratio changes? d) Repeat the exercise in part (d) assuming that T = 20 and = |Tp=r=010. ₂ 3. Assume that the expected earnings before interest and taxes (EBIT) is E(X)= X and so the expected returns net of taxes of an unlevered firm is (1-1)X, where , represents the marginal corporate income tax rate. On the other hand, for an equal-size levered firm with the same EBIT and with a permanent level of debt D, in the capital structure and r being the rate of interest on the debt, the expected returns net of taxes will be X* =(1-c)(X -rD₂) +rD₂. Now consider that investors are subject to personal taxes and capital gain taxes. That is, a dollar of profit after tax will be subject to personal tax if paid out as dividend or capital gain tax if reinvested by the firm. Interest on debt is always subject to personal tax. Leto represent the dividend payout ratio and Tep, and represent rates of corporate tax, personal tax and capital gains respectively. Let * be the rate at which the market capitalizes the uncertain stream of returns and r be the rate at which the market capitalizes the sure streams generated by debts. Modigliani and Miller (1963) argued that annual tax saving from the use of debt should be capitalized at a lower rate and that r<p². Required: a) Show the after-tax returns to the stockholders of the unlevered fim. What will be the after-tax returns to stockholders and bondholders of the levered firm? b) What will be the values of the levered firm compared with that of the unlevered firm? c) Consider X = 1000, D₁ = 4000, r=0.05, p = 0.10, and T =.40. If personal taxes and capital gain taxes exist and T, (= 0.10) < (= 0.25), show the value of the levered firm compared with that of the unlevered firm when 0-0.00, 0.50, and 1.00. How does the capital structure change as the payout ratio changes? d) Repeat the exercise in part (d) assuming that T = 20 and = |Tp=r=010. ₂

Answer rating: 100% (QA)

a Aftertax returns to stockholders of the unlevered firm The aftertax returns to stockholders of the unlevered firm can be calculated by multiplying t... View the full answer