Question

Fid Corp is considering a capital restructuring in which it would pay a large, special dividend financed with new debt. Its total capitalization of $100 million would not change but its Debt to Capitalization would increase from 20% to 60%. Fid currently pays 3%/year on its debt, but its investment bankers estimate the interest rate would increase to 6%/year at 60% Debt to Capitalization.

1. Given the information above, what is the capital structure ($Debt + $Equity = $Total Capitalization) for A) Fid’s current capital structure and B) the proposed structure?

2. What is the EBIT Break Even for each capital structure?

3. Given Fid Corp’s effective tax rate of 28% (Federal + State), calculate the Tax Shield for each capital structure.

4. Given Fid Corp’s tax rate of 28%, what is the actual after-tax interest rate for each capital structure?

Name the 3 benefits that Fid Corp would achieve for its shareholders under the capital restructure proposed assuming operating results (EBIT) do not change.

Answer 1

1.Capital structure

Given that the total capitalisation= $ 100 mlns.

Current

Debt= 100*20%= $ 20 mlns.

Equity= 100*(1-20%)= $ 80 mlns

Proposed

Debt= 100*60%= $ 60 mlns.

Equity= 100*(1-60%)= $ 40 mlns

2.EBIT breakeven for each capital structure is

the respective interest expenses, ie. EBIT-Interest expense =0

Current = 20 mln.*3%=

0.6

mlns

Proposed=60mln*6%=

3.6

mlns.

3.Tax Shield for each capital structure

Tax shield = Annual Interest *Tax rate

Current

(20 mln*3%)*28%=

0.168

milllion

Proposed

60 mln.*6%*28%=

1.008

mln.

4.Actual after-tax interest rate for each capital structure=

Interest rate*(1-Tax Rate)

Current

3%*(1-28%)=

2.16%

Proposed

6%*(1-28%)=

4.32%

5. Assuming operating results (EBIT) do not change

3 benefits that Fid Corp would achieve for its shareholders under the capital restructure proposed are :

a. Increased cash flow with in the firm , to the extent of tax expense saved, ie.1.008 mln.-0.168 mln.= 0.84 mln.

b. Upto a certain level, use of borrowed funds is less costlier, as overall cost of capital , decreases , with increase in debt--- compared to more equity in the capital structure.

c. Use of optimal level of debt , increases , or even maximises ,firm value for shareholders.

d. There is an opportunity for the company to explore a larger variety of sources of funds , rather than depend on equity only