Consider an economy with three investor groups. The personal tax rates on interest income are 12 percent, 21 percent, and 35 percent, respectively, for these three groups. The corporate tax rate is 35 percent, and the effective tax rate on equity distributions is zero. The after-tax required rate of return on all equity financed projects is 10.5 percent.

a. What is the equilibrium interest rate?

b. For this interest rate, will each of the three groups prefer debt or equity?

c. If firm A has earnings before interest and taxes (EBIT) of $1 million in perpetuity, what is its value? Does the firm’s value vary with different capital structure choices?