Question

Herculio Mining has net operating income of $6 million; there is $60 million of debt outstanding with a required rate of return of 6 percent; the required rate of return on the industry is 12 percent; and the corporate tax rate is 35 percent. Assume there are corporate taxes but no personal taxes.

a) Calculate total income available to investors. (Marks: 4) Please show your calculations clearly

b) Determine the present value of the interest tax shield of Herculio Mining, as well as the total value of the firm. (Marks: 3) Please show your calculations clearly

c) Determine the gain from leverage if personal taxes of 18 percent on stock income and 28 percent on debt income exist. (Marks: 3) Please show your calculations clearly

Answer 1

Herculio Mining
a..	$ Mlns.
Net operating income	6
Less: Interest on debt(60*6%)	3.6
Income before tax	2.4
Less: Income tax at 35%(2.4*35%)	0.84
Net income	1.56
So, answer a .will be
Total income available to investors	1.56

b. Present value of the interest tax shield of Herculio Mining= 3.6/12%	30
PV of perpetuity ,ie. (Interest expense*Tax rate) /year discounted at theinvestors' reqd. rate of return on the industry,ie. 3.6/12%=
Total Value of firm= Market value of Equity+MV of Debt+PV of Interest Tax Shields
ie.(Total income available to investors)/Their reqd. return)+MV of debt+PV Of ITS
ie.(1.56/12%)+60+30=
103
Millions

c. Gain from leverage can be found out using the formula,

Gain from leverage=1(-((1-Corporate tax Rate)*(1-Personal income tax Rate to Common stock))/(1-Personal Income tax rate on Debt)))*Market Value of Debt

Ie Gain from leverage=(1-((1-35%)*(1-18%)/(1-28%)))*60

15.583333

Millions