Question

Brenda is planning to form a company. She has determined that $10 million will be required as an initial capital investment. Brenda can borrow the capital personally, or her new company can issue debentures. Brenda has delineated three alternative financing plans:

1. Form the company with 1 million shares of $10 par value, borrowing the entire $10 million on a personal basis (paying 10% interest).

2. Form the company with 500,000 shares of $10 par value, borrowing $5 million on a personal basis (paying 10% interest). Sell $5 million worth of 10 per cent debentures.

3. Sell $10 million worth of 10 per cent debentures.

The company is expected to earn $2 million per year before the payment of interest and taxation (if applicable).

1. Assuming no corporate or personal taxes, which of the three alternatives should Brenda select? Assume that all of net earnings are paid out in dividends.

(1) Refer to the M&M proposition. Answer without making any calculations.

(2) Confirm your answer with the calculations.

(3) Now assume the debentures issued by the company have only to pay 8% interest rate. Redo the calculation and answer: Does it alter your selection?

2. Assuming a 28% company income tax and a personal marginal income tax rate for Brenda of 33%, which of the three alternatives should Brenda select? Assume that all of net earnings are paid out in dividends and dividend imputation is not applicable.

(1) Refer to the M&M proposition. Answer without making any calculations.

(2) Confirm your answer with the calculations.

(3) Now assume Brenda’s personal marginal income tax rate is 17.5%. Redo the calculation and answer: Does it alter your selection?

Answer 1

1	As per M&M proposition, the value of a company remain same
	irrespective of its capital structure. So Brenda should get the
	same return from all three types of capital structure.

Ans 2
1	Equity	$       10,000,000
	No of shares	$         1,000,000
	EBIT =Net Earning =Total Dividend =	$         2,000,000
	Less Personal Loan Interest on $10M @10%=	$         1,000,000
	Net Income for Brenda	$         1,000,000
2	Equity	$         5,000,000
	No of shares	$            500,000
	Debenturue	$         5,000,000
	Interest on debenture	$            500,000
	EBIT	$         2,000,000
	EBT=Dividend received by Brenda	$         1,500,000
	Less Personal Loan Interest on $5M @10%=	$            500,000
	Net Income for Brenda	$         1,000,000
3	Equity sahres	$                       -
	Debentures	$       10,000,000
	Interest on debentures @10%	$         1,000,000
	EBIT	$         2,000,000
	EBT =Net income to Brenda	$         1,000,000
	So in all the three cases net income to Brenda
	is $1M

Ans 3.

	Now debeture rate is changed to 8%
1	Equity	$       10,000,000
	No of shares	$         1,000,000
	EBIT =Net Earning =Total Dividend =	$         2,000,000
	Less Personal Loan Interest on $10M @10%=	$         1,000,000
	Net Income for Brenda	$         1,000,000
2	Equity	$         5,000,000
	No of shares	$            500,000
	Debenturue	$         5,000,000
	Interest on debenture @8%	$            400,000
	EBIT	$         2,000,000
	EBT=Dividend received by Brenda	$         1,600,000
	Less Personal Loan Interest on $5M @10%=	$            500,000
	Net Income for Brenda	$         1,100,000
3	Equity sahres	$                       -
	Debentures	$       10,000,000
	Interest on debentures @8%	$            800,000
	EBIT	$         2,000,000
	EBT =Net income to Brenda	$         1,200,000
	So in this cas the net income to Breanda in increasing with
	increase of Debt in Capital.
	However as per M&M , as the debt part increases , the cost of
	equity also increases to have the same cost of capital.
	Here we have not considered an increase in equity cost, therefore
	there is increase in return with increase in debt.