Question

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 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) Find after-tax cash flow to debtholders from the new debt

b) 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?

c) Find Rally’s effective tax advantage of debt. How is it related to cash flows you computed in questions a) and b)

d) 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

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Answer 1

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 after recapitalisation. The proceeds of debt issue are paid to the shareholders and not reinvested to the company. The company will have to pay interest of $15,000,000. There is a tax advantage of debt of $6,000,000. So in turn the free cash flow of the company will decrease by $9,000,000. This will reduce the value of the company. The expected decrease in value can be calculated by dividing $9,000,000 by the cost of capital