Chapter 17: Capital Structure: Limits to the Use of Debt

Questions and Problems:

17.1 a. Using M&M Proposition I with taxes, the value of a levered firm is:

VL = [EBIT(1 – tC)/r0] + tCB

VL = [$975,000(1 – 0.35)/0.14] + 0.35($1,900,000)
VL = $5,191,785.71

b. The CFO may be correct. The value calculated in part a does not include the costs of any non-
marketed claims, such as bankruptcy or agency costs.

17.2 a. Debt issue:

The company needs a cash infusion of $1.2 million. If the company issues debt, the annual interest
payments will be:

Interest = $1,200,000(0.08) = $96,000

The cash flow to the owner will be the EBIT minus the interest payments, or:

40 hour week cash flow = $400,000 – $96,000 = $304,000

50 hour week cash flow = $500,000 – $96,000 = $404,000

Equity issue:

If the company issues equity, the company value will increase by the amount of the issue. So, the
current owner’s equity interest in the company will decrease to:

Tom Scott’s ownership percentage = $2,500,000 / ($2,500,000 + $1,200,000) = 0.6757

So, Tom Scott’s cash flow under an equity issue will be 67.57 percent of EBIT, or:

40 hour week cash flow = 0.6757($400,000) = $270,280

50 hour week cash flow = 0.6757($500,000) = $337,850

b. Tom Scott will work harder under the debt issue since his cash flows will be higher. Tom Scott will
gain more under this form of financing since the payments to bondholders are fixed. Under an
equity issue, new investors share proportionally in his hard work, which will reduce his propensity
for this additional work.

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 c. The direct cost of both issues is the payments made to new investors. The indirect costs to the debt
issue include potential bankruptcy and financial distress costs. The indirect costs of an equity issue
include shirking and perquisites.

17.3a. The interest payments each year will be:

Interest payment = 0.08($70,000) = $5,600

This is exactly equal to the EBIT, so no cash is available for shareholders. Under this scenario, the
value of equity will be zero since shareholders will never receive a payment. Since the market value
of the company’s debt is $70,000, and there is no probability of default, the total value of the
company is the market value of debt. This implies the debt to value ratio is 1 (one).

b. At a 3 percent growth rate, the earnings next year will be:

Earnings next year = $5,600(1.03) = $5,768

So, the cash available for shareholders is:

Payment to shareholders = $5,768 – $5,600 = $168

Since there is no risk, the required return for shareholders is the same as the required return on the
company’s debt. The payments to stockholders will increase at the growth rate of three percent (a
growing perpetuity), so the value of these payments today is:

Value of equity = $168 / (0.08 – 0.03) = $3,360.00

And the debt to value ratio now is:

Debt/Value ratio = $70,000 / ($70,000 + $3,360) = 0.954

c. At a 7 percent growth rate, the earnings next year will be:

Earnings next year = $5,600(1.07) = $5,992.00

So, the cash available for shareholders is:

Payment to shareholders = $5,992 – $5,600 = $392

Since there is no risk, the required return for shareholders is the same as the required return on the
company’s debt. The payments to stockholders will increase at the growth rate of seven percent (a
growing perpetuity), so the value of these payments today is:

Value of equity = $392 / (0.08 – 0.07) = $39,200

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 And the debt to value ratio now is:

Debt/Value ratio = $70,000 / ($70,000 + $39,200) = 0.641

17.4According to M&M Proposition I with taxes, the value of the levered firm is:

VL = VU + tCB
VL = $14,500,000 + 0.35($5,000,000)
VL = $16,250,000

We can also calculate the market value of the firm by adding the market value of the debt and equity.
Using this procedure, the total market value of the firm is:

V=B+S
V = $5,000,000 + 300,000($35)
V = $15,500,000

With no nonmarketed claims, such as bankruptcy costs, we would expect the two values to be the same.
The difference is the value of the nonmarketed claims or VN, which are:

VT = VM + VN
$15,500,000 = $16,250,000 – VN
VN = $750,000

17.5 The president may be correct, but he may also be incorrect. It is true the interest tax shield is valuable,
and adding debt can possibly increase the value of the company. However, if the company’s debt is
increased beyond some level, the value of the interest tax shield becomes less than the additional
costs from financial distress, resulting in an overall decrease in firm value.

17.6 a. The total value of a firm’s equity is the discounted expected cash flow to the firm’s stockholders. If
the expansion continues, each firm will generate earnings before interest and taxes of $2,700,000. If
there is a recession, each firm will generate earnings before interest and taxes of only $1,100,000.
Since Steinberg Corporation owes its bondholders $900,000 at the end of the year, its stockholders
will receive $1,800,000 (= $2,700,000 – 900,000) if the expansion continues. If there is a recession,
its stockholders will only receive $200,000 (= $1,100,000 – 900,000). So, assuming a discount rate
of 13 percent, the market value of Steinberg Corporation’s equity is:

SSteinberg = [0.80($1,800,000) + 0.20($200,000)] / 1.13 = $1,309,735

Steinberg’s bondholders will receive $900,000 whether there is a recession or a continuation of the
expansion. So, the market value of Steinberg’s debt is:

BSteinberg = [0.80($900,000) + 0.20($900,000)] / 1.13 = $796,460

Since Dietrich Corporation owes its bondholders $1,200,000 at the end of the year, its stockholders
will receive $1,500,000 (= $2,700,000 – 1,200,000) if the expansion continues. If there is a

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 recession, its stockholders will receive nothing since the firm’s bondholders have a more senior
claim on all $1,100,000 of the firm’s earnings. So, the market value of Dietrich Corporation’s
equity is:

SDietrich = [0.80($1,500,000) + 0.20($0)] / 1.13 = $1,061,947

Dietrich Corporation’s bondholders will receive $1,200,000 if the expansion continues and
$1,100,000 if there is a recession. So, the market value of Dietrich Corporation’s debt is:

BDietrich = [0.80($1,200,000) + 0.20($1,100,000)] / 1.13 = $1,044,248

b. The value of the company is the sum of the value of the firm’s debt and equity. So, the value of
Steinberg Corporation is:

VSteinberg = B + S
VSteinberg = $796,460 + $1,309,735
VSteinberg = $2,106,195

And value of Dietrich Corporation is:

VDietrich = B + S
VDietrich = $1,044,248 + $1,061,947
VDietrich = $2,106,195

You should disagree with the CEO’s statement. The risk of bankruptcy per se does not affect a
firm’s value. It is the actual costs of bankruptcy that decrease the value of a firm. Note that this
problem assumes that there are no bankruptcy costs.

17.7 a. The expected value of each project is the sum of the probability of each state of the
economy times the value in that state of the economy. Since this is the only project for the
company, the company value will be the same as the project value, so:

Low-volatility project value = 0.50($2,500) + 0.50($2,700)

Low-volatility project value = $2,600

High-volatility project value = 0.50($2,100) + 0.50($2,800)

High-volatility project value = $2,450

The low-volatility project maximizes the expected value of the firm.

b. The value of the equity is the residual value of the company after the bondholders are paid off. If
the low-volatility project is undertaken, the firm’s equity will be worth $0 if the economy is bad
and $200 if the economy is good. Since each of these two scenarios is equally probable, the
expected value of the firm’s equity is:

Expected value of equity with low-volatility project = 0.50($0) + 0.50($200)

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 Expected value of equity with low-volatility project = $100

And the value of the company if the high-volatility project is undertaken will be:

Expected value of equity with high-volatility project = 0.50($0) + 0.50($300)

Expected value of equity with high-volatility project = $150

c. Risk-neutral investors prefer the strategy with the higher expected value. Thus, the company’s
stockholders prefer the high-volatility project since it maximizes the expected value of the
company’s equity.

d. In order to make stockholders indifferent between the low-volatility project and the high-volatility
project, the bondholders will need to raise their required debt payment so that the expected value of
equity if the high-volatility project is undertaken is equal to the expected value of equity if the low-
volatility project is undertaken. As shown in part a, if the high-volatility project is undertaken, the
value of the firm will be $2,100 if the economy is bad and $2,800 if the economy is good. If the
economy is bad, the entire $2,100 will go to the bondholders and stockholders will receive nothing.
If the economy is good, stockholders will receive the difference between $2,800, the total value of
the firm, and the required debt payment. Let X be the debt payment that bondholders will require if
the high-volatility project is undertaken. In order for stockholders to be indifferent between the two
projects, the expected value of equity if the high-volatility project is undertaken must be equal to
$100, so:

Expected value of equity = $100 = 0.50($0) + 0.50($2,800 – X)

X = $2,600

17.8 a. The expected payoff to bondholders is the face value of debt or the value of the
company, whichever is less. Since the value of the company in a recession is $85 million and the
required debt payment in one year is $120 million, bondholders will receive the lesser amount, or
$85 million.

b. The promised return on debt is:

Promised return = (Face value of debt / Market value of debt) – 1

Promised return = ($120,000,000 / $94,000,000) – 1
Promised return = 0.2766 or 27.66%

c. In part a, we determined bondholders will receive $85 million in a recession. In a boom, the
bondholders will receive the entire $120 million promised payment since the market value of the
company is greater than the payment. So, the expected value of debt is:

Expected payment to bondholders = 0.60($120,000,000) + 0.40($85,000,000)

Expected payment to bondholders = $106,000,000

So, the expected return on debt is:

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 Expected return = (Expected value of debt / Market value of debt) – 1
Expected return = ($106,000,000 / $94,000,000) – 1
Expected return = 0.1277 or 12.77%

17.9 a. In their no tax model, MM assume that tC, tB, and C(B) are all zero. Under these assumptions, VL =
VU, signifying that the capital structure of a firm has no effect on its value. There is no optimal
debt-equity ratio.

b. In their model with corporate taxes, MM assume that tC > 0 and both tB and C(B) are equal to zero.
Under these assumptions, VL = VU + tCB, implying that raising the amount of debt in a firm’s capital
structure will increase the overall value of the firm. This model implies that the debt-equity ratio of
every firm should be infinite.

c. If the costs of financial distress are zero, the value of a levered firm equals:

VL = VU + {1 – [(1 – tC) / (1 – tB) ]} B

Therefore, the change in the value of this all-equity firm that issues debt and uses the proceeds to
repurchase equity is:

Change in value = {1 – [(1 – tC) / (1 – tB)}] B

Change in value = {1 – [(1 – 0.34) / (1 – 0.20)]} × $1,000,000
Change in value = $175,000

d. If the costs of financial distress are zero, the value of a levered firm equals:

VL = VU + {1 – [(1 – tC) / (1 – tB)]} B

Therefore, the change in the value of an all-equity firm that issues $1 of perpetual debt instead of $1
of equity is:

Change in value = {1 – [(1 – tC) / (1 – tB)]} × $1

If the firm is not able to benefit from interest deductions, the firm’s taxable income will remain the
same regardless of the amount of debt in its capital structure, and no tax shield will be created by
issuing debt. Therefore, the firm will receive no tax benefit as a result of issuing debt in place of
equity. In other words, the effective corporate tax rate when we consider the change in the value of
the firm is zero. Since this firm is not able to deduct interest payments, the change in value is:

Change in value = {1 – [(1 – 0) / (1 – 0.20)]} × $1

Change in value = –$0.25

The value of the firm will decrease by $0.25 if it adds $1 of perpetual debt rather than $1 of equity.

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17.10 a. If the company decides to retire all of its debt, it will become an unlevered firm. The value of an all-
equity firm is the present value of the aftertax cash flow to equity holders, which will be:

VU = (EBIT)(1 – tC) / r0
VU = ($1,300,000)(1 – 0.35) / 0.20
VU = $4,225,000

b. Since there are no bankruptcy costs, the value of the company as a levered firm is:

VL = VU + {1 – [(1 – tC) / (1 – tB)}] B

VL = $4,225,000 + {1 – [(1 – 0.35) / (1 – 0.25)]} × $2,500,000
VL = $4,558,333.33

The company should choose to repurchase stock instead of retiring its debt.

c. The bankruptcy costs would not affect the value of the unlevered firm since it could never be forced
into bankruptcy. So, the value of the levered firm with bankruptcy would be:

VL = VU + {1 – [(1 – tC) / (1 – tB)}] B – C(B)

VL = ($4,225,000 + {1 – [(1 – 0.35) / (1 – 0.25)]} × $2,500,000) – $400,000
VL = $4,158,333.33

The company should choose the all-equity plan with this bankruptcy cost.

17.11 a. The value of the unlevered firm is:

VL = [EBIT(1 – tC)/r0] = $200,000 × (1 – 0.4) / 0.1 = $1,200,000

b. The value of the levered firm is:

VL = VU + {1 – [(1 – tC) × (1 – tS) / (1 – tB)]} B

VL = $1,200,000 + 0.4 × $100,000 = $1,240,000

c. The value of the levered firm is:

VL = VU + {1 – [(1 – tC) × (1 – tS) / (1 – tB)]} B

VL = $1,200,000 + {1 – [(1 – 0.4) × (1 – 0.25) / (1 – 0.4)]} × $100,000 = $1,225,000

d. The value of the levered firm is:

VL = VU + {1 – [(1 – tC) × (1 – tS) / (1 – tB)]} B

VL = $1,200,000 + {1 – [(1 – 0.4) × (1 – 0.25) / (1 – 0.55)]} × $100,000 = $1,200,000

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e. The value of the levered firm is:

VL = VU + {1 – [(1 – tC) × (1 – tS) / (1 – tB)]} B

VL = $1,200,000 + {1 – [(1 – 0.4) × (1 – 0.25) / (1 – 0.7)]} × $100,000 = $1,150,000

f. The gain in firm value from leverage decreases as the gap between the personal tax rate on interest
and the personal tax rate on equity distributions widens. In particular, when the personal tax rate on
equity distributions is 25 percent and the personal tax rate on interest is 70 percent, the value of the
levered firm becomes smaller than the value of the unlevered firm. This is because the increase in
taxes from leverage at the personal level exceeds the increase in interest tax savings at the corporate
level.

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MINI-CASE: McKenzie Restaurants Capital Budgeting

1. We assume the $5,700,000 is spent over the course of the year so we can ignore time value of money
considerations. If we include the time value of money, the numerical solutions will change slightly, but
the analysis will remain the same. The expected value of the company in one year without expansion is:

V = 0.30($25,000,000) + 0.50($30,000,000) + 0.20($48,000,000)

V = $32,100,000

And the expected value of the company in one year with expansion is:

V = 0.30($27,000,000) + 0.50($37,000,000) + 0.20($57,000,000)

V = $38,000,000

2. The value of the company’s debt with low economic growth is the value of the company because the
company value is less than the face value of the debt. In both other economic states, the value of the debt
is the face value of the debt. So, the expected value of debt in one year without expansion is:

VD = 0.30($25,000,000) + 0.50($29,000,000) + 0.20($29,000,000)

VD = $27,800,000

And the value of the company’s debt in one year with expansion is:

VD = 0.30($27,000,000) + 0.50($29,000,000) + 0.20($29,000,000)

VD = $28,400,000

3. The value of the company’s equity with low economic growth is zero both with and without expansion
since the company value will be less than the face value of the debt. The value of equity with normal
growth or high growth is the value of the company minus the $29,000,000 face value of debt. So, the
expected value of the equity without expansion is:

VE = 0.30($0) + 0.50($1,000,000) + 0.20($19,000,000)

VE = $4,300,000

And the value of equity with expansion is:

VE = 0.30($0) + 0.50($8,000,000) + 0.20($28,000,000)

VE = $9,600,000

The value expected for bondholders from the expansion is the difference in the expected value of debt.
So, with expansion, the company’s bondholders gain:

Bondholder gain = $28,400,000 – $27,800,000

Bondholder gain = $600,000

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 And the value expected for stockholders is:

Stockholder gain = $9,600,000 – $4,300,000

Stockholder gain = $5,300,000

The stockholder value increases by $5,300,000, but the expansion was funded entirely by equity, so the
expected NPV of expansion for stockholders is actually:

Stockholder NPV = $5,300,000 – $5,700,000

Stockholder NPV = –$400,000

4. Assuming bondholders are fully informed and they act rationally, they will expect the stockholders to act
in their best interest and not expand, so the price of the bonds will not change. If the expansion is
announced, the price of the bonds will increase.

5. If they don’t expand, nothing will happen since it is already priced into the bond. If the company
announces the expansion, they signal they are willing to sacrifice for the bondholders, so the company
will receive a lower interest rate in the future.

6. It is a stronger signal that stockholders are not acting in their best interest if the expansion is financed
with cash on hand. If the company issues new equity, the expected loss in stock value is shared
proportionally by the new investors, so the current stockholders will not bear the entire loss in stock
value alone. By expanding with cash on hand, current stockholders are bearing the entire expected loss
in stock value.

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Appendix

17.B1 a. According to the Miller Model, in equilibrium:

rB (1 – tC) = rS
rB (1 – 0.35) = 0.10.5
rB = 0.105 / (1 – 0.35)
= 0.1615

The equilibrium interest rate is 16.15%.

b. In order to determine whether each group would prefer to hold debt or equity, it is necessary
to compare the after–personal tax interest rate to the required return on unlevered equity for
each of the three groups of investors. A group of investors will prefer to hold the security that
offers them the highest rate of return.

The required rate of return to equity holders is 10.5%. Since the effective personal tax rate on
equity distributions is zero, personal taxes do not change the required return to equity holders.

The market interest rate on debt is 16.15%.

The after–personal tax interest rate for investors who face a 12% tax on interest income is
14.21% {= 0.1615 * (1 – 0.12)}. Since the after–personal tax interest rate (14.21%) is greater
than the required return on equity (10.5%), this group is better off holding debt.

Investors whose interest income is taxed at 12% will buy debt.

The after–personal tax interest rate for investors who face a 21% tax on interest income is
13.37% {= 0.1615 * (1 – 0.21)}. Since the after–tax interest rate (13.37%) is greater than the
required return on equity (10.5%), this group is also better off holding debt.

Investors whose interest income is taxed at 21% will buy debt.

The after–personal tax rate interest rate for investors who face a 40% tax on interest income is
10.49% {= 0.1615 * (1 – 0.40)}. Since the after–tax interest rate (9.69%) is less than the
required return on equity (10.5%), this group is also better off holding equity.

Investors whose interest income is taxed at 35% will buy equity.

c. According to the Miller Model, firm value does not vary with capital structure in equilibrium.
Therefore, Firm A’s value would be equal to an all–equity financed firm with EBIT of $1
million in perpetuity.

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 VA = [(EBIT)(1 – tC)] / rS
= [($1,000,000)(1 – 0.35)] / 0.105
= $6,190,476.19
The value of Firm A is $6,190,476.19.

17. B2 a. According to the Miller Model, in equilibrium:

rB (1 – tC) = rS
rB (1 – 0.39) = 0.091
rB = 0.091 / (1 – 0.39)
= 0.1491

The equilibrium market rate of interest is 14.91%.

b. In order to determine whether each group would prefer to hold debt or equity, compare the
after–personal tax interest rate on debt to the required return on unlevered equity for each of
the three groups of investors. A group of investors will prefer to hold the security that offers
them the highest rate of return.

The required rate of return to equity holders is 9.1%. Since the effective personal tax rate on
equity distributions is zero, personal taxes do not change the required return to equity holders.

The market interest rate is 14.91%.

Group A faces a 45% tax on interest income. The after–personal tax interest rate for investors
in Group A is 8.20% {= 0.1491 * (1 – 0.45)}. Since the after–personal tax interest rate
( 8,20%) is less than the required return on equity (9.1%), Group A will buy equity.

Group A will buy equity.

Group B faces a 34% tax on interest income. The after–personal tax interest rate for investors
in Group B is 9.84% {= 0.1491 * (1 – 0.34)}. Since the after–personal tax interest rate
( 9.84%) is greater than the required return on equity (9.1%), Group B will buy debt.

Group B will buy debt.

Group C faces a 12% tax on interest income. The after–personal tax rate interest rate for
investors in Group C is 13.12% {= 0.1491 * (1 – 0.12)}. Since the after–personal tax interest
rate ( 13.12%) is greater than the required return on equity (9.1%), Group C will buy
debt.

Group C will buy debt.

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c. The total market value of all companies is the sum of the market value of debt and the market
value of equity for each firm. From part b, we know that investors in Group B and Group C
will invest in debt. Therefore, their investable funds comprise the total market value of debt
in the economy. The market value of debt is $329 million (= $219 million + $110 million).
Since there are $85 million of corporate earnings in perpetuity and the all–equity discount rate
is 9.1%, the market value of equity in the economy is:

Equity Value= (EBIT –{rB*B})(1 – tC) / rS

= ($85 million – { 0.1491 * $329 million})(1 – 0.39) / 0.091
= $240.96 million

The market value of equity is $240.96 million.

In reality, the value of the equity should be exactly equal to Group A’s investable funds, in
order for the market to be in equilibrium. The required return on equity is determined in
equilibrium by the amount of available funds from investors who wish to buy equity. Had
there been more (less) funds available for equity investment, the required return on equity
would be lower (higher).

Therefore, the market value of all companies is:

VL = B + S
= $329million + $240.96 million
= $569.96 million

The market value of all companies is $569.96 million.

d. The total tax bill is the sum of the taxes paid by corporations and individuals.

Corporate Taxes:

Corporate Taxes = tC * Earnings After Interest

=tC * (EBIT –{rB* B})
= 0.39 * ($85 million – { 0.1491 * $329 million})
= $14,018,979

Personal Taxes:

There are no taxes on equity distributions:

Interest Income:

Group A holds no debt and therefore earns no interest income.

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 Group B holds $219 million of debt and is subject to a personal tax rate on interest income of
34%.

Group B’s Personal Taxes = TB * (B * rB)

= 0.34 * ($219 million *0.1491)
= $ 11,101,986

Group C holds $110 million of debt and is subject to a personal tax rate on interest income of
12%.

Group C’s Personal Taxes= TB * (B * rB)

= 0.12 * ($110 million *0.1491)
= $1,968,120

The total amount of personal taxes is $13,070,106 (=$ 11,101,986+ $1,968,120).

Total Tax Bill = Corporate Taxes + Personal Taxes

= $14,018,979+ $13,070,106
= $27,089,085

The total tax bill is $27,089,085

17. B3 a. According to the Miller Model, in equilibrium:

rB (1 – tC) = rS
rB (1 – 0.38) = 0.08
rB = 0.08 / (1 – 0.38)
= 0.129

Corporations pay an interest rate of 12.9%.

In order to determine whether each group would prefer to hold debt or equity, compare the
after–personal tax interest rate on debt to the required return on unlevered equity for each of
the four groups. A group will prefer to hold the security that offers them the highest rate of
return.

The required rate of return to equity holders is 8%. Since equity income is untaxed at the
personal level, personal taxes do not change the required return to equity holders.

The market interest rate on debt is 12.9%.

Group L faces a 45% tax on interest income. The after–personal tax interest rate for investors
in Group L is 7.095% {= 0.129 * (1 – 0.45)}. Since the after–personal tax interest rate
(7.095%) is less than the required return on equity (8%), Group L will buy equity.

Group L will buy equity with its $450 million of wealth.

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 Group M faces a 35% tax on interest income. The after–personal tax interest rate for investors
in Group M is 8.385% {= 0.129 * (1 – 0.35)}. Since the after–personal tax interest rate
(8.385%) is greater than the required return on equity (8%), Group M will buy debt.

Group M will buy debt with its $400 million of wealth.

Group N faces a 25% tax on interest income. The after–personal tax rate interest rate for
investors in Group N is 9.67% {= 0.129 * (1 – 0.25)}. Since the after–personal tax interest
rate (9.67%) is greater than the required return on equity (8%), Group N will buy debt.

Group N will buy debt with its $150 million of wealth.

Group O pays no tax on interest income. The after–personal tax rate interest rate for investors
in Group O is 12.9% {= 0.129 * (1 – 0)}. Since the after–personal tax interest rate (12.9%) is
greater than the required return on equity (8%), Group O will buy debt.

Group O will buy debt with its $475 million of wealth.

The total market value of all companies is the sum of the market value of debt and the market
value of equity for each firm. From above, we know that investors in Group M, Group N and
Group O will invest in debt. Therefore, their investable funds comprise the total market value
of debt in the economy. The market value of debt is $1025million (= $400 million + $150
million+$475 million). Since there are $145 million of corporate earnings in perpetuity and
the all–equity discount rate is 8%, the market value of equity in the economy is:

The value of equity in the economy can be computed using the following expression:

Equity Value = ($145 million – {0.129 * $1025 million})(1 – 0.38)) / 0.08

= $99.00625 million

The debt–equity ratio in the economy is 99.00625/1025= 0.09659.

b. According to the Miller Model, in equilibrium:

rB (1 – tC) = rS
rB (1 – 0.27) = 0.08
rB = 0.08 / (1 – 0.27)
rB = 0.1096

Corporations pay an interest rate of 10.96%.

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

© 2019 McGraw-Hill Education Ltd.
17-15
In order to determine whether each group would prefer to hold debt or equity, compare the
after–personal tax interest rate on debt to the required return on unlevered equity for each of
the four groups. A group will prefer to hold the security that offers them the highest rate of
return.

The required rate of return to equity holders is 8%. Since equity income is untaxed at the
personal level, personal taxes do not change the required return to equity holders.

The market interest rate on debt is 10.96%.

Group L faces a 45% tax on interest income. The after–personal tax interest rate for investors
in Group L is 6.028% {= 0.1096 * (1 – 0.45)}. Since the after–personal tax interest rate
(4.29%) is less than the required return on equity (8%), Group L will buy equity.

Group L will buy equity with its $450 million of wealth.

Group M faces a 35% tax on interest income. The after–personal tax interest rate for investors
in Group M is 7.124% {= 0.1096 * (1 – 0.35)}. Since the after–personal tax interest rate
(7.124%) is less than the required return on equity (8%), Group M will buy equity.

Group M will buy equity with its $400 million of wealth.

Group N faces a 25% tax on interest income. The after–personal tax rate interest rate for
investors in Group N is 8.22% {= 0.1096 * (1 – 0.25)}. Since the after–personal tax interest
rate (8.22%) is greater than the required return on equity (8%), Group N will buy debt.

Group N will buy debt with its $150 million of wealth.

Group O pays no tax on interest income. The after–personal tax rate interest rate for investors
in Group O is 10.96% {= 0.1096 * (1 – 0)}. Since the after–personal tax interest rate (10.96%)
is greater than the required return on equity (8%), Group O will buy debt.

Group O will buy debt with its $475 million of wealth.

Therefore, the value of debt in the economy is $625 million (= $150 million + $475 million).

The value of equity in the economy can be computed using the following expression:

Equity Value = (EBIT – rBB)(1 – tC) / rS

Equity Value = ($145million – {0.1096 * $625 million})(1 – 0.27)) / 0.08
= $698.0625 million

The debt–equity ratio in the economy is 0.8953 (= $625 million / $698.0625 million).

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

© 2019 McGraw-Hill Education Ltd.
17-16