RMO is an all-equity firm that has never actively managed its capital structure in the past....
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RMO is an all-equity firm that has never actively managed its capital structure in the past. It currently has 4 million shares outstanding and its share price is at 25. The firm's new CEO has heard about the "tax shield of debt effect" and is fascinated by the idea of increasing the firm's market value just by substituting debt for equity. a) If RMO operated in perfect capital markets without any taxes (no corporate or personal taxes), how will RMO's market value change if the firm decides to issue 50 million € of debt, buying back 50 million € of common stock in return? In this scenario RMO will pay interest only on this debt and plans to hold that amount of debt permanently without further adjustments in the future. (2 points) b) In contrast to a) above assume now that there is a corporate tax with statutory rate of 35% (but no personal tax- es). What would be the effect of the same financial transactions on RMO's value? (5 points) c) Personal taxes on investors' income (from either interest payments on corporate debt, dividends or capital gains) might offset some of the tax benefits of leverage. Suppose the tax rate on interest income is 35% and the tax rate on dividends as well as capital gains is 10% for all investors. How high must the (marginal) corporate tax rate be for debt to still offer a tax advantage? (5 points) c) The CEO is skeptical about these valuation effects and seeks your advice. She asks whether there are also costs to debt financing not adequately accounted for in these calculations so far. What could these costs of leverage be? (3 points) d) Assume again that there is only a corporate tax with tax rate 35% (like in question b) above; no personal taxes). After several days of hard analytical work, you have come up with some estimates of the costs of leverage consi- dered in c) above. Firstly, the one-time upfront investment banking fees associated with this financial transaction will add up to 5% of the debt amount raised. Secondly, you find all other costs of leverage to be quite sensitive to the amount of debt raised with relative costs rising with the level of debt financing. The following table shows your esti- mates of the present value of costs of leverage (excluding one-time upfront investment banking fees) depending upon the amount of debt raised. Debt amount (in million $) Present value of ex- pected cost of leverage 0.0 (in million $) Which level of debt is best for RMO? 0 10 0.3 20 1.8 30 4.3 40 7.5 50 11.3 RMO is an all-equity firm that has never actively managed its capital structure in the past. It currently has 4 million shares outstanding and its share price is at 25. The firm's new CEO has heard about the "tax shield of debt effect" and is fascinated by the idea of increasing the firm's market value just by substituting debt for equity. a) If RMO operated in perfect capital markets without any taxes (no corporate or personal taxes), how will RMO's market value change if the firm decides to issue 50 million € of debt, buying back 50 million € of common stock in return? In this scenario RMO will pay interest only on this debt and plans to hold that amount of debt permanently without further adjustments in the future. (2 points) b) In contrast to a) above assume now that there is a corporate tax with statutory rate of 35% (but no personal tax- es). What would be the effect of the same financial transactions on RMO's value? (5 points) c) Personal taxes on investors' income (from either interest payments on corporate debt, dividends or capital gains) might offset some of the tax benefits of leverage. Suppose the tax rate on interest income is 35% and the tax rate on dividends as well as capital gains is 10% for all investors. How high must the (marginal) corporate tax rate be for debt to still offer a tax advantage? (5 points) c) The CEO is skeptical about these valuation effects and seeks your advice. She asks whether there are also costs to debt financing not adequately accounted for in these calculations so far. What could these costs of leverage be? (3 points) d) Assume again that there is only a corporate tax with tax rate 35% (like in question b) above; no personal taxes). After several days of hard analytical work, you have come up with some estimates of the costs of leverage consi- dered in c) above. Firstly, the one-time upfront investment banking fees associated with this financial transaction will add up to 5% of the debt amount raised. Secondly, you find all other costs of leverage to be quite sensitive to the amount of debt raised with relative costs rising with the level of debt financing. The following table shows your esti- mates of the present value of costs of leverage (excluding one-time upfront investment banking fees) depending upon the amount of debt raised. Debt amount (in million $) Present value of ex- pected cost of leverage 0.0 (in million $) Which level of debt is best for RMO? 0 10 0.3 20 1.8 30 4.3 40 7.5 50 11.3
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a In perfect capital markets without any taxes the market value of the firm is not affected by the capital structure changes The total market value of the firm remains the same regardless of whether i... View the full answer
Related Book For
Fundamentals Of Corporate Finance
ISBN: 9781265553609
13th Edition
Authors: Stephen Ross, Randolph Westerfield, Bradford Jordan
Posted Date:
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