Question

The CFO of Microsoft is considering a leveraged recapitalization pitched by Goldman Sachs. Under the plan, Goldman would underwrite the flotation of a $10 billion bond, with a maturity of 20 years, with the coupon rate equal to the risk-free rate on Treasury bonds, rf =4%. Microsoft’s debt is viewed by the markets as risk free.

At the end of 20 years, Microsoft will “roll - over” the bond. That is, at maturity it will issue a new bond with identical provisions to the first bond. The $10 billion received for the new bond will be used to cover the principal payment ($10 billion) due under the terms of the first bond. This process will be repeated every 20 years. In this way, Microsoft’s interest expense into perpetuity will be identical to that on a consol bond with an annual coupon of $400 million.

Microsoft’s estimated corporate tax rate is 36%. Under the terms of the deal, Goldman agrees to place all future bond issues for free. However, it demands up-front compensation for its services. In particular, it demands a fee equal to F times the market price of the first bond issued.

Using the information provided, answer the questions below.

a) What is the maximum value of F such that the deal is still worth doing from the perspective of Microsoft’s shareholders?

b) What is the value of tax shield from the deal?

c) Now assume that firm’s profits are paid out to shareholders as dividends and the tax rate that shareholders pay on dividend income is estimated to be 15%. Note that, under this assumption, proceeds from issuing the bond will be taxed when paid as dividends . However, further dividends will be reduced by the interest payments and therefore shareholders should pay less dividend income tax in perpetuity . What is the maximum value of F?

Answer 1

a) What is the maximum value of F such that the deal is still worth doing from the perspective of Microsoft’s shareholders?

The maximum value of F such that the deal is still worth doing from the perspective of Microsoft’s shareholders be up to PV of Tax shield. As there is no extra cost bear by company other than interest on debt and tax shield is savings on interest on debt. Which will not hamper the profit of the share holders of the company.

b) What is the value of tax shield from the deal?

Tax shield from the deal is 36% of tax on interest paid on the bonds :

Annual Tax Shield : 36% x $ 400 million = $ 144 million

This Tax shield is for perpetual as such bond is refunded by issuing new bond every time for infinite period or at perpetuity. Also, it is given that this debt is risk free debt hence discount rate is same as risk free rate.

Hence,

PV Tax shield ( perpetuity) = $ 144 million / 4% = $ 3600 million

c) Now assume that firm’s profits are paid out to shareholders as dividends and the tax rate that shareholders pay on dividend income is estimated to be 15%. Note that, under this assumption, proceeds from issuing the bond will be taxed when paid as dividends . However, further dividends will be reduced by the interest payments and therefore shareholders should pay less dividend income tax in perpetuity . What is the maximum value of F?

As given in the question that dividends will be reduced by the interest payments and therefore shareholders should pay less dividend income tax in perpetuity. Hence, such tax benefit can be considered additionally while calculation value of F.

Maximum value of F = PV of Tax shield of Interest on debt at perpetuity + PV of tax saved by shareholders due to debt at perpetuity

Maximum value of F = $ 144 million / 4% + ( ($ 400 million x(1 - 36% ) x 15% )/4%)

Maximum value of F = $ 3600 million + $ 960 million = $ 4560 million