David Lyons, CEO of Lyons Solar Technologies, is d.
Now suppose investors are subject to the follow-
concerned about his firm’s level of debt financing. ing tax rates: Td 30% and Ts 12%. The company uses short-term debt to finance its (1) What is the gain from leverage according to temporary working capital needs, but it does not use the Miller model? any permanent (long-term) debt. Other solar tech- (2) How does this gain compare with the gain nology companies average about 30 percent debt, in the MM model with corporate taxes? and Mr. Lyons wonders why they use so much more (3) What does the Miller model imply about the debt and how it affects stock prices. To gain some effect of corporate debt on the value of the insights into the matter, he poses the following ques- firm; that is, how do personal taxes affect tions to you, his recently hired assistant: the situation? e. What capital structure policy recommendations a. BusinessWeek recently ran an article on compa- do the three theories (MM without taxes, MM nies’ debt policies, and the names Modigliani and with corporate taxes, and Miller) suggest to Miller (MM) were mentioned several times as financial managers? Empirically, do firms appear leading researchers on the theory of capital struc- to follow any one of these guidelines? ture. Briefly, who are MM, and what assumptions f. How is the analysis in part c different if firms U are embedded in the MM and Miller models? and L are growing? Assume that both firms are b. Assume that Firms U and L are in the same risk growing at a rate of 7 percent and that the class, and that both have EBIT $500,000. investment in net operating assets required to Firm U uses no debt financing, and its cost of support this growth is 10 percent of EBIT. equity is rsU 14%. Firm L has $1 million of g. What if L’s debt is risky? For the purpose of this debt outstanding at a cost of rd 8%. There are example, assume that the value of L’s operations no taxes. Assume that the MM assumptions is $4 million—which is the value of its debt plus hold, and then: equity. Assume also that its debt consists of (1) Find V, S, rs, and WACC for Firms U and L. 1-year zero-coupon bonds with a face value of (2) Graph (a) the relationships between capital $2 million. Finally, assume that L’s volatility is 0.60 costs and leverage as measured by D/V, and ( 0.60) and that the risk-free rate is 6 percent. (b) the relationship between value and D. h. What is the value of L’s stock for volatilities c. Using the data given in part b, but now assum- between 0.20 and 0.95? What incentives might ing that firms L and U are both subject to a 40 the manager of L have if she understands this percent corporate tax rate, repeat the analysis relationship? What might debtholders do in called for in b(1) and b(2) under the MM with- response? tax model.