Determining the marginal corporate tax

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1. ABC and XYZ are identical firms in all respects except for their capital structure. ABC is all equity financed with \$800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth \$400,000 and the interest rate on its debt is 10%. Both firms expect EBIT to be \$95,000 and all income will be distributed as dividends. Ignore taxes.

a. Richard owns \$30,000 worth of XYZ stock. What rate of return is he expecting?

b. Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage

c. Now assume ABC and XYZ each pay a 20% marginal corporate tax, but Richard pays no taxes. Repeat a) and b). How is the outcome different than in a) and b)? Explain. Which firm would Richard prefer to invest in? Why?

d. Now assume ABC and XYZ each pay a 20% marginal corporate tax, and Richard pays a 15% tax on dividends. Repeat a) and b). How is the outcome different than in a), b), and c)? Explain. Which firm would Richard prefer to invest in? Why?

2. Shadow Corp. has no debt but can borrow at 7%. The firm's WACC is currently 11%, and the tax rate is 35%.

a. What is Shadow's cost of equity?

b. If the firm converts to a 25% debt-to-equity ratio, what will its cost of equity be?

c. What is Shadow's WACC after it converts to the 25% debt-to-equity ratio?

d. Assume that converting to the 25% debt-to-equity ratio does not significantly increase Shadow Corp.'s probability of bankruptcy. Should Shadow Corp. convert to the new capital structure? Explain.

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