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.

b) Determine the present value of the interest tax shield of Herculio Mining, as well as the total value of the firm.

c) Determine the gain from leverage if personal taxes of 18 percent on stock income and 28 percent on debt income exist.

Please show your calculations clearly.

Answer 1

Ans. (a) Total income available to investor :-

= Net Operating Income (1- tax rate)

= $6 million (1 - 0.35)

= $ 3.9 million

(b) PV of Interet Tax shield :-

PV of Tax Shield = Debt ∗ Tax rate = $60 million ∗ 0.35= $ 27 million

Total value of firm :

The M&M proposition states that value of a levered firm is composed of the present value of unlevered value and the tax shield produced by employing leverage(debt). Since interest is tax-deductible, the leverage increases the firm value.

The value of a levered firm comprises the present value of the unlevered value of the firm and tax shield of the firm.

VL=PV of Unlevered firm value + PV of Tax Shield

Using the industry's required rate of return (R), the value of the firm is calculated as below:

VL = EBIT (1−T) / R + $16million

=$ 6 million(1−0.35)/0.12 + $ 27 million

=$ 32.50 million + $ 27 million

= $ 59.50 million

(c) Gain from leverage:

Since the Net operating income is $6million, the after-tax earnings is $3.9 million [$6million(1-0.35)]. Investors receive stock income in the form of dividends and capital gains. Therefore, with a 18% personal tax rate, investors receive only $3.198million [$3.9million(1-0.18)] if all earnings in the current year are disbursed.

For investors who hold debt income, the income comes in the form of interest. $60 million debt produces an interest income of $ 3.60 million which is deducted from the personal tax rate of 28%. Thus, the after-tax interest income for investors is $ 2.592 million [$3.60 million(1-0.28)].