Question

Consider a firm that is 100% equity financed. The expected net operating income is 200 million, the corporate tax rate is 35%, and the cost of capital is 8%.

(a) Construct the balance sheet.

(b) The firm decides to borrow 1000 million at the interest rate 5%. The proceeds are used to repurchase equity in the same amount. Construct the balance sheet with debt financing taking into account the tax deductability of interest.

(c) What is cost of equity after the repurchase?

(d) What is the loss of tax revenues due to the tax deductability of interest?

Answer 1

Net operating profit	200
(less) Tax @ 35%	70
Amount available for distribution to owners	130
Rate of return expected by owners	8%
Equity capital	1625

Balance sheet
Asset	Amount	Liability	amount
Bank	1625	Equity	1625
Receivable	200	Operating income (200-(200*.35)	130
		Income tax payable	70

Net profit	200
Interest on debt	50
	150
Tax @35%	52.5
	97.5

Opening Equity	1625
equity bought back	1000
closing equity	625

Balance sheet with debt
Asset	Amount	Liability	amount
Bank	1625	Equity	625
Receivable	200	Operating income	97.5
		Income tax payable	52.5
		Interest payable	50
		Debt	1000

cost of equity after repurchase
equity	625
Net operating income available for owners	97.5
cost of equity	15.60%

Calculation of loss in tax revenues
Tax under no debt scenario	70
Tax under debt scernario	52.5
Loss in tax revenues due to deductibility of interest	17.5