In: Finance
Rally, Inc., currently an all-equity firm, is considering adding permanent debt 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.
a) The after tax cash flow to debt holders will be $10,500,000
b) The after tax cash flow to investors would have been $7,200,000
c) The tax advantage of debt is $6,000,000
d) The value of the company is expected to decrease. The proceeds from the debt issue will be used to pay the investors rather than re-investing. The company will have to pay an interest of $15,000,000 and the company will also have a tax advantage of debt of $6,000,000. In turn the free cash flow of the company wll reduce by $9,000,000. The expected reduction in the value of the company can be calculated by dividing $9,000,000 by its cost of capital