Question

Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. Assume that the firm's gain from leverage according to the Miller model is $126,667.

1. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?
a. 16.4%b. 18.2%c. 25.0%d. 20.2%e. 22.5%

Answer 1

implied personal tax on debt income = 25%

so correct option is c. 25.0%

Step-by-step explanation:

given data

expected EBIT = $100,000

corporate tax rate T = 30%

debt amount = $500,000

debt rate = 12%

cost of equity same risk Ru = 16.0%

to find out

implied personal tax rate on debt income

solution

we get here value of unlevered firm that is express as

value of unlevered firm =
`(EBIT(1-T))/(Ru)` ..........1

put here value

value of unlevered firm Vu =
`(100000(1-0.30))/(0.16)`

value of unlevered firm Vu = $437500

and

now we get here value of levered firm that is express as

value of levered firm = value of unlevered firm + tax × debt ..........2

value of levered firm = $437500 + $500000 × ( 0.30)

value of levered firm = $587500

and

now we get implied personal tax on debt income

implied personal tax on debt income = 1 -
`(126667)/(150000*(1.12))`

implied personal tax on debt income = 0.2460

implied personal tax on debt income = 25%

so correct option is c. 25.0%