Giant Tricycles Ltd., has $2 million in earnings before interest and taxes. Currently it is all- equity-financed. It can issue $4 million in perpetual debt at 15% interest in order to repurchase stock, thereby recapitalising the corporation. There are no personal taxes.
- If the corporate tax rate is 30%, what is the income available to all security holders if the company remains all-equity-financed? If it is recapitalised?
- What is the present value of the debt tax-shield benefits?
- The equity capitalization rate for the company’s common stock is 20% while it remains all-equity-financed.
(i) What is the value of the firm if it remains all-equity financed?
(ii) What is the firm’s value if it is recapitalised?
- All-equity Debt and Equity
EBIT $2,000,000 $2,000,000
Interest to debt holders 0 600,000
EBT $2,000,000 $ 1,400,000
Taxes (30%) 600,000 420,000
Incomes available to common shareholders $ 1,400,000 $ 980,000
Income to debt holders plus income
available to shareholders $1,400,000 $1,580,000
- Present value of tax-shield benefits = (B)(tc) = ($4,000,000)(0.30) = $1,200,000
- Value of all-equity financed firm = EAT/ke = $1,400,000/(0.20) = $7,000,000
Value of recapitalized firm = $7,000,000 + $1,200,000 = $8,200,000
