Question

C&J Enterprises is an all-equity firm that is considering issuing $13.5 million of perpetual debt. The interest rate is 10%. The firm will use the proceeds of the bond sale to repurchase equity. The firm distributes all earnings available to stockholders immediately as dividends. The firm will generate $3 million of earnings before interest and taxes (EBIT) every year into perpetuity. The firm is subject to a corporate tax rate of 40%. Suppose the personal tax rate on interest income is 55%, and the personal tax rate on equity income is 20%.

a. What is the annual after-tax cash flow to equity holders under each plan?

	Unlevered	Levered
EBIT	$3 million	$3 million
Interest	$0 million	$1.35 million =$13.5 m*0.1
EBT	$3 million	$1.65 million
Corporate Taxes	$1.2 million	$0.66 million
Net Income	$1.8 million	$0.99 million

b. What is the annual after-tax cash flow to debt holders under each plan?

c. Does debt still have an advantage over equity in this case, and why?

Answer 1

Particulars	Amount ($)
A. Incremental Revenue from Bud Company	8000
B.Incremental Cost
Direct Material (2000 [email protected])	4200
Direct Labour (2000 Units @1.3)	2600
Variable Manufacturing Overhead([email protected])	720
Total Cost	7520
Incremental Contribution (A-B)	480

Hence Flowers should accept the order from Bud Company as it will give incremental contribution of $480.

Note Per Unit Material Cost = $21000/10000 units = $2.1 per unit

          Per Unit Labour Cost = $13000/10000 units = $1.3 per unit

          Per Unit Variable Mfg. Cost = ($9000*40%)/10000 units = $0.36 per unit

               

Particulars	Unlevered	Levered
EBIT	3	3
Interest	0	1.35
EBT	3	1.65
Corporate Tax	1.2	0.66
PAT	1.8	0.99

A.After Tax Cash flow of Equity Holders

Particulars	Unlevered (in $ Million)	Levered (in $ Million)
PAT	1.8	0.99
Tax on Equity Income (20%)	(0.36)	(0.20)
After Cash Flow to Equity Holders	1.44	0.79

B. After Tax Cash flow of Debt Holders

Particulars	Unlevered	Levered
(in $ Million)	(in $ Million)
Interest Income	0	1.35
Tax on Equity Income (55%)	0	(0.74)
After Cash Flow to Debt Holders	0	0.61

C. In my opinion debt does not have advantage over equity as consider in absolute terms, the after cash flow to equity holders is higher than the after cash flow to debt holders. Mere advantage to debt holders is fixed payment of interest whether there is profit is available or not. And in this case sufficient profits are available. However, answer may change if total no. of shares and debt were given because in that case per share and debt the income will be calculated and compared. But since the same is not given, it is consider that debt does not have advantage over equity

Particulars	Unlevered	Levered
EBIT	3	3
Interest	0	1.35
EBT	3	1.65
Corporate Tax	1.2	0.66
PAT	1.8	0.99