Question

Windsor, Inc. is currently an all-equity financed firm, and its cost of equity is 12%. It has 20,000 shares outstanding that sell for $25 each. The firm contemplates a restructuring that would borrow $100,000 in perpetual debt at an interest rate of 8% which will be used to repurchase stock. Assume that the corporate tax rate is 35%.

(1) Calculate the present value of the interest tax shields and the value of the firm after the proposed restructuring.

(2) What will be shareholders’ required rate of return after the proposed restructuring? Is it higher or lower than 12%? Why or why not?

Answer 1

1) Interest paid every year = $100000 *8% =$8000

Tax saved each year = $8000 *35% =$2800 for perpetuity

So, present value of tax shields = Annual Tax savings/ Cost of Debt = $2800/0.08 = $35000

As per MM proposition with taxes

Value of levered firm = Value of Unlevered firm + PV of tax shields

After restructuring , the firm will become a levered firm (with debt)

The value of unlevered firm = No. of shares * market price of one share

=20000* $25

=$500000

So, value of  firm after restructuring = $500000+ $35000 =$535,000

2)   As per MM proposition with taxes

Cost of levered equity = cost of unlevered equity+ (cost of unlevered equity-cost of debt) * D/E* (1-t)

where D is the market values of Debt ($100000)

and E is the market value of Equity = $400000 (after stock repurchase)+ $35000 =$435000

and t is the tax rate

Cost of unlevered equity = 12%

So, Cost of levered equity = 12%+ (12%-8%)*100000/435000*(1-0.35)= 12.5977%

The shareholders required rate of return after restructuring will be 12.5977%

It is higher than 12% because with debt, the risk of the firm increases and returns to shareholders become more risky , hence the required rate of return rises to compensate this risk.