Exercise sheet 3.

Corporate Finance Winter 2012/2013

Exercise 1
A rm has a current debt/equity ratio of 2:3. It is worth $10 billion, of which $4 billion is debt.
The rm's overall cost of capital is 12%, and its debt currently pays an (expected) interest rate
of 5%. The rm estimates that its debt rating would deteriorate if it were to renance to a 1:1
debt/equity ratio through a debt-for-equity exchange ($5 billion equity and $5 billion debt), so
it would have to pay an expected interest rate of 5.5%. The rm is solidly in a 35% corporate
income tax bracket. The rm reported net income of $500 million and plans to maintain a
constant debt/equity ratio over time. On a corporate income tax basis only, ignoring all other
capital structure related eects, what would you estimate the value consequences for this rm
to be? What would be the stock's announcement price reaction?

≈ 3.65%

Exercise 2
Can you use the standard CAPM with the tax-adjusted WACC formula?

From a theoretical point of view: no. The standard CAPM assumes a perfect
market, which is distorted by including taxes. Nevertheless, both WACC and
CAPM frameworks are concurrently used in practice.

Exercise 3
With current leverage, Impi Corp. will have net income next year of 4.5 million Euro. If Impi's
corporate tax rate is 35% and it pays 8% interest on its debt, how much additional debt can
Impi issue this year and still receive the benet of the interest tax shield next year?

86.5 million Euro.

Exercise 4
Kohwe Corporation plans to issue equity to raise $50 million to nance a new investment. After
making the investment, Kohwe expects to earn free cash ows of $10 million each year. Kohwe

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currently has 5 million shares outstanding, and it has no other assets or opportunities. Suppose
the appropriate discount rate for Kohwe's future free cash ows is 8%, and the only capital
market imperfections are corporate taxes and nancial distress costs.

a.) What is Kohwe's share price today?

$15.

b.) Suppose Kohwe borrows the $50 million instead. The rm will pay interest only on this
loan each year, and it will maintain an outstanding balance of $50 million on the loan.
Suppose that Kohwe's corporate tax rate is 40%, and expected free cash ows are still $10
million each year. What is Kohwe's share price today if the investment is nanced with
debt?

$19.

c.) Now suppose that with leverage, Kohwe's expected free cash ows will decline to $9 million
per year due to reduced sales and other nancial distress costs. Assume that the appropriate
discount rate for Kohwe's future free cash ows is still 8%. What is Kohwe's share price
today given the nancial distress costs of leverage?

$16.50.

Exercise 5
Real estates are often nanced with more than 80% debt. Many rms exhibit instead debt retios
below 50%. Provide a reason for this observation.

We can use the trade-o theory. The costs of nancial distress a likely to be small
for real estates. (They can easily be sold at the market.) Firms typically face much
higher costs of nancial distress. They use therefore less debt.

Exercise 6
After investors receive cash ows, they are generally taxed again. For individuals, interest pay-
ments received from debt are taxed as income. Equity investors also must pay taxes on dividends
and capital gains.

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a.) Derive a formula for the eective tax advantage of debt τ ∗ , i.e. the percentage a cash ow
that equity holders receive less after taxes than debt holders?

(1−τi )−(1−τc )(1−τe ) (1−τc )(1−τe )

τ∗ = (1−τi ) =1− (1−τi )

see also Berk/DeMarzo, 2011, page 490 and 491

b.) Assume that the corporate tax rate is 46%, interest income is taxed with 70%, and equi-
ty income (dividends and capital gains) are taxed with 50%. Calculate the eective tax
advantage and interpret the result relative to corporate tax rate.

τ ∗ = 0.1

c.) Assume that the corporate tax rate is 34%, interest income is taxed with 28%, and equi-
ty income (dividends and capital gains) are taxed with 28%. Calculate the eective tax
advantage and interpret the result relative to corporate tax rate.

τ ∗ = 0.34

d.) What are the consequences to rm value of these additional taxes for a rm with permanent
debt and homogenous investors?

Use APV: V L = V U + τ ∗ · D
Using WACC, the equity and debt costs of capital must be adjusted.

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Exercise 7
Suppose the tax rate on interest income is 50%, and the average tax rate on capital gains and
dividend income is 25%. How high must the marginal corporate tax rate be for debt to oer a
tax advantage?

τc > 1/3 ≈ 33.3%

Exercise 8
You can take a 1 million Euro project. However, this kind of project is ordinary income for you,
and it will produce either nothing or 3 million Euro next year, both with equal probabilities.
Assume that your taxable opportunity cost of capital is 10% and your combined tax rate is 35%.
Your after-tax cost of capital is thus 6.5% (also relevant for the tax shelter).

a.) What is the project worth? Assume that you could fully use tax losses to oset other
income taxed at 35%, too.

244,131 Euro.

b.) How would your answer change if you could not use the tax losses elsewhere?

79,812 Euro.