Question

Fortune Enterprises is an all-equity firm that is considering issuing $13.5 million of perpetual debt. The interest rate is 10%. The firm will use the proceeds of the bond sale to repurchase equity. Fortune distributes all earnings available to stockholders immediately as dividends. The firm will generate $3 million of earnings before interest and taxes (EBIT) every year into perpetuity. Fortune is subject to a corporate tax rate of 40%. Suppose the personal tax rate on interest income is 55%, and the personal tax rate on equity income is 20%.

What is the annual after-tax cash flow to debt holders under each plan?

a. Debt holders get $0 mil. under the unlevered plan vs. 1.2 mil. under the levered plan
b. Debt holders get $1.2 mil. under the unlevered plan vs. 0.66 mil. under the levered plan
c. Debt holders get $0 mil. under the unlevered plan vs. 0.66 mil. under the levered plan
d. Debt holders get $0 mil. under the unlevered plan vs. 0.6075 mil. under the levered plan

Answer 1

d. Debt holders get $0 mil. under the unlevered plan vs. 0.6075 mil. under the levered plan

Step-by-step explanation:

interests paid to debt holders = $13,500,000 x 10% = $1,350,000

generally, interest revenue is taxed as ordinary revenue = corporate income tax rate (if debt holder is a business) or personal income tax (if debt holder is an individual).

under the first plan, debt holders get nothing because there is no outstanding debt since the company is an all equity firm.

under the second plan, if the personal tax rate on interest income is 55%, which is really high, the debt holders will earn $1,350,000 x (1 - 55%) = $607,500