Question

1. Suppose the corporate tax rate is 40%, investors pay a tax rate of 20% on income from dividends or capital gains and a tax rate of 30% on interest income.

Rally, Inc., currently an all-equity firm, is considering adding permanentdebt through a levered recapitalization (Rally plans to raise 300 million through debt and payout the proceeds to shareholders). Interest Rally will be paying each year is expected to be $15 million. Rally will pay this interest expense by cutting its dividend.

1. Find after-tax cash flow to debtholders from the new debt
2. How much shareholders would receive in after-tax money (out of those $15 million that would be designated for dividends) if the firm did not change its capital structure?
3. Find Rally’s effective tax advantage of debt. How is it related to cash flows you computed in questions a) and b)
4. Compute expected change in the value of the company after the recapitalization. Does the value of the company increase or decrease as a result of recapitalization? Explain briefly

Answer 1

a) After tax cash flow to debtholders = Interest (1- Tax Rate on Interest)

= 15 (1- 0.30)

= 10.50 million

b) If there was no change in capital structure, shareholders dividend after tax cashflow = Dividend (1- Tax on Dividend)

= 15 ( 1 - 0.2)

= 12 million

c) Interest is tax deductible. Hence interest helps in reducing profit before tax, thereby reducing the taxes to be paid by the company

Effective tax advantage of debt = Interest * Corporate Tax Rate = 15 * 40% = 6 million

Hence if company is paying interest, effective interest of only 9 million (15-6) is paid by the company, however, company had to pay dividend of 15 million

d) Expected change in value of recapitalisation.

As per Modigilani Approach Preposition I (With No Taxes), value of the enterprise does not depend on the capital structure of the firm. This preposition assumes no tax environment. The approach assumes that any reduction on cost of debt, in turn increases the cost of equity such that overall cost of capital is unchanged thereby the value of the firm is unchanged.

Under the Modigilani Approach Preposition I (With Taxes), the value of the firm will increase if the tax picture is considered. Hence value of firm will only increase by the tax portion of debt.

Change in the value of the company = Debt * Tax Rate = 300 * 40% = 120 million

Value of the company is expected to increase as a result of recapitalisation.