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).

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

	Assuming Brenda can tax benefit of the intersest
	on personal loan as it was taken for business purpose
		Calculation with personal Marginal Tax 33%	Calculation with personal Marginal Tax 17.5%
1	Equity	$ 10,000,000	$   10,000,000
	No of shares	$   1,000,000	$     1,000,000
	EBIT	$   2,000,000	$     2,000,000
	Tax @28%	$      560,000	$        560,000
	PAT =Net dividend	$   1,440,000	$     1,440,000
	Less Personal Loan Interest on $10M @10%=	$   1,000,000	$     1,000,000
	Net Income for Brenda	$      440,000	$        440,000
	Personal Marginal Tax	145,200.00	77,000.00
	After Tax Income for Brenda	$      294,800	$        363,000

2	Equity	$   5,000,000	$     5,000,000
	No of shares	$      500,000	$        500,000
	Debenturue	$   5,000,000	$     5,000,000
	Interest on debenture	$      500,000	$        500,000
	EBIT	$   2,000,000	$     2,000,000
	EBT=	$   1,500,000	$     1,500,000
	Tax @28%	$      420,000	$        420,000
	PAT =Net dividend	$   1,080,000	$     1,080,000
	Less Personal Loan Interest on $5M @10%=	$      500,000	$        500,000
	Net Income for Brenda	$      580,000	$        580,000
	Personal Marginal Tax	$ 191,400.00	$   101,500.00
	After Tax Income for Brenda	$ 388,600.00	$   478,500.00

3	Equity sahres	$                 -
	Debentures	$ 10,000,000	$   10,000,000
	Interest on debentures @10%	$   1,000,000	$     1,000,000
	EBIT	$   2,000,000	$     2,000,000
	EBT =	$   1,000,000	$     1,000,000
	Tax @28%	$      280,000	$        280,000
	PAT =Net dividend	$      720,000	$        720,000
	Net Income for Brenda	$      720,000	$        720,000
	Personal Marginal Tax	$      237,600	$ 126,000.000
	After Tax Income for Brenda	$      482,400	$        594,000

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.

2	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.
	This is not happening here , the benefit to Brenda in increasing
	as the % of Debt increasing
	So Brenda should select Option 3.

3	If the personal marginal Tax rate reduces to 17.5% ,
	the selection does not change as per the calculation in
	the 2nd column of tables.