Harrys Potter's yearly earnings depend on the local weather conditions. If the weather over the year is
Question:
Harry’s Potter's yearly earnings depend on the local weather conditions. If the weather over the year is good (which happens with a probability of .4), Harry’s Potter's pre-tax earnings are high and are equal to $1.4m for the year. If instead local weather turns out to be on average fair (which happens with probability .3), Harry’s Potter's pre-tax earnings are only $1.1m. Finally, if average weather is bad (which happens with probability .3) pre-tax earnings are only $.8m. All of Harry’s Potter's risk is therefore non-systematic. In addition, for tax purposes, Harry’s Potter has depreciation deductions every year of $.4m. The corporate tax rate is τC=35%, the personal tax rate on equity income is τE=14%, and the personal tax rate on interests τP = 28%. The rate on tax-free bonds is r 0=7%. How much debt should Harry’s Potter have in its capital structure?
Using the probabilities. It's based on the debt levels and the tax benefit of debt.
Probability and Statistics for Engineers and Scientists
ISBN: 978-0495107576
3rd edition
Authors: Anthony Hayter