1.Apple Corporation had no debt on its balance sheet in 2008, but paid $2 billion in taxes. Suppose Apple were to issue sufficient debt to reduce its taxes by $1 billion per year permanently. Assume Apple’s marginal corporate tax rate is 35% and its borrowing cost is 7.5%.
a. If Apple’s investors do not pay personal taxes (because they hold their Apple stock in taxfree retirement accounts), how much value would be created (what is the value of the tax shield)?
b. How does your answer change if instead you assume that Apple’s investors pay a 15% tax rate on income from equity and a 35% tax rate on interest income?
2.Markum Enterprises is considering permanently adding $100 million of debt to its capital structure. Markum’s corporate tax rate is 35%.
a. Absent personal taxes, what is the value of the interest tax shield from the new debt?
b. If investors pay a tax rate of 40% on interest income, and a tax rate of 20% on income from dividends and capital gains, what is the value of the interest tax shield from the new debt?
3.Garnet Corporation is considering issuing risk-free debt or risk-free preferred stock. The tax rate on interest income is 35%, and the tax rate on dividends or capital gains from preferred stock is 15%. However, the dividends on preferred stock are not deductible for corporate tax purposes, and the corporate tax rate is 40%.
a. If the risk-free interest rate for debt is 6%, what is cost of capital for risk-free preferred stock?
b. What is the after-tax debt cost of capital for the firm? Which security is cheaper for the firm?
c. Show that the after-tax debt cost of capital is equal to the preferred stock cost of capital multiplied by (1 . ô*).
4.Suppose the tax rate on interest income is 35%, and the average tax rate on capital gains and dividend income is 10%. How high must the marginal corporate tax rate be for debt to offer a tax advantage?
5.With its current leverage, Impi Corporation will have net income next year of $4.5 million. 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 benefit of the interest tax shield next year?
6.Colt Systems will have EBIT this coming year of $15 million. It will also spend $6 million on total capital expenditures and increases in net working capital, and have $3 million in depreciation expenses. Colt is currently an all-equity firm with a corporate tax rate of 35% and a cost of capital of 10%.
a. If Colt is expected to grow by 8.5% per year, what is the market value of its equity today?
b. If the interest rate on its debt is 8%, how much can Colt borrow now and still have nonnegative net income this coming year?
c. Is there a tax incentive for Colt to choose a debt-to-value ratio that exceeds 50%? Explain.
7. PMF, Inc., is equally likely to have EBIT this coming year of $10 million, $15 million, or $20 million. Its corporate tax rate is 35%, and investors pay a 15% tax rate on income from equity and a 35% tax rate on interest income.
a. What is the effective tax advantage of debt if PMF has interest expenses of $8 million this coming year?
b. What is the effective tax advantage of debt for interest expenses in excess of $20 million? (Ignore carryforwards.)
c. What is the expected effective tax advantage of debt for interest expenses between $10 million and $15 million? (Ignore carryforwards.)
d. What level of interest expense provides PMF with the greatest tax benefit?