(a) Copper Systems is expected to have a net income of $15 million this coming year. Copper is currently an all-equity firm with a corporate tax rate of 22% and a cost of capital of 10%.

(i) If the interest rate on its debt is 7%, how much should Copper borrow to maximize the benefit of the interest tax shield this coming year?

(ii) From a tax perspective, does Copper have an incentive to increase its debt beyond the level in part (i)? Both corporate and personal taxes are considered.

(7 marks)

(b) Zinc Manufacturing is currently an all-equity firm with 20 million outstanding shares and a stock price of $8.50 per share. Now Zinc plans to borrow $30 million on a permanent basis and use the borrowed funds to repurchase shares. Zinc is subject to a 25% corporate tax rate.

(i) What is the market value of Zinc’s assets (including any tax shields) just after the debt is issued, but before the shares are repurchased?

(ii) Suppose Zinc offers $9 to repurchase the shares. Will shareholders tender their shares? If so, how many shares will be repurchased?

(iii) What is the market value of Zinc’s assets after the share repurchase? What is Zinc’s share price after the share repurchase?

(10 marks)

(c) The spot exchange rate for the British Pound is $1.45/£. Steel Industries enters into a contract to purchase goods with a price of £400,000 to be delivered in one year. There is a one-year call option contract available to Steel which allows the company to buy £10,000 for $1.50/£. The company has purchased 40 option contracts.

(i) If the spot rate in one year is $1.87/£, will Steel exercise the option? How much will Steel pay for the goods?

(ii) If the spot rate in one year is $1.36/£, will Steel exercise the option? How much will Steel pay for the goods

Answer rating: 100% (QA)

ANSWER a i To maximize the benefit of the interest tax shield Copper should borrow an amount such that the tax savings from the interest expense equals the additional tax paid on the earnings before i... View the full answer