Smeal College of Business Taxation and Management Decisions: ACCTG 550Pennsylvania State University Professor HuddartAdaptation of Problem 18.1: Leverage1. ProblemFrom: Chapter 18 of Scholes and Wolfson, pp. 391–392A manufacturing corporation owns tangible fixed assets that cost $100million. The $100 million was financed by an equity offering of equal amount.The assets are specialized and have no value in use other than to produce thesole product that the firm sells to its wholesale distributors. There is no debtin the firm’s capital structure. Its reinvestment opportunities are poor, sothe firm distributes all profits as earned. As a consequence, the corporationhas no accumulated earnings and profits. The firm’s manufacturing activitiesgenerate a pretax profit of $10 million per year, year in and year out. Thisreturn of 10% of the cost of the fixed assets is equal to the rate of returnearned on riskless bonds in the marketplace. The corporate tax rate is 40%,and the personal tax rate on income (including dividend income) is 30%.1.1 Facts and notation• A corporation has $100m of tangible fixed assets and no debt.• The assets have no other use.• Shareholders have a basis of $100m in their shares.• The corporation pays out its entire after-tax profits each year since ithas no super-competitive projects in prospect.• The competitive rate of return is R = 10%.• all earnings, net of tax, are paid out as dividends.• The corporate tax rate, T ,is40%.• The personal tax rate, t,is30%.• The capital gains tax rate is g = 30%.cSteven Huddart, 1995–2005. All rights reserved. www.smeal.psu.edu/faculty/huddartACCTG 550 Problem 18.1: Leverage1.2 Questions(1) What is the current market value of the stock?Answer: The market value of the unlevered corporationis:$10m(1 − 40%)(1 − 30%)10%(1 − 30%)= $60m.(2) How much better off are the corporation’s shareholders if the corporationissues $100m of debt and uses the proceeds to buy back shares?Answer: Issuing $100m of debt yielding 10% could be usedto repurchase $100m of stock. Then, the value of the debtwould be:$10m(1 − 30%)10%(1 − 30%)= $100mThis will reduce corporate income to zero. There wouldbe zero residual value for (non-existent) shareholders whowould have received $100m for their shares.• Shareholders and debtholders are better off becausethe interest income they receive in place of dividendswill escape a round of tax at the corporate level.(3) What impediments exist to issuing enough debt to repurchase all thestock?Answer:• All corporations must have some equity.–Inthe US, the thin capitalization rules in §385limit the amount of debt that can be issued by acorporation.• Issuing this amount of debt may alter the way thefirm is run and lead to conflict among stakeholders.– This conflict would be diminished if the allstakeholders could agree implicitly to hold debtand stock in the same proportions. This issometimes called strip financing. Of course,the IRS could challenge a structure in whichPage 2Problem 18.1: Leverage ACCTG 550debt and equity must explicitly be held in strictproportion.• Bondholders could require restrictive covenants.• The chance of costly default increases as the firmbecomes more levered.• Bonds are less liquid than stock, so the transferabilityof ownership may be impaired.1.3 Revised fact• the assets within the corporation earn the super-competitive rate ofreturn of 40%;1.4 More questions(4) What is the current market value of the stock?Answer: The current market value of stock (computed bycapitalizing the future dividend stream) is$40m(1 − 40%)(1 − 30%)7%= $240m.(5) As a partnership, how much are the assets worth?Answer: As a partnership, the assets are worth$40m(1 − 30%)7%= $400m.(6) How much must be borrowed to wipe out the corporation’s taxableincome?Answer: To generate enough interest expense to offsetincome, $400m must be borrowed.Note: The proceeds from issuing the debt can be used to repurchase stock.(7) How much do former shareholders receive for their shares?Page 3ACCTG 550 Problem 18.1: LeverageAnswer: If the capital gains tax rate is g = 30%, then theformer shareholders get 400 − g(400 − 100) = $310m fortheir shares.(8) Reconcile the difference between $240m and $310m.Answer:40% savings on thecompetitive return$10m(1−t).07× 40%=40(40% − g)=10% savings onthe super-competitive return$30m×10%(1−t).07=3070Observation: It is not possible to shelter all of the excess return on the firm’s assets(i.e., the return in excess of 10%) from corporate level tax by levering thecorporation, because of capital gains taxation. The unsheltered amountis$30m × g(1 − t).07=$30m × .30(1 − .30).07= $90m.(9) How would the analysis change for a tax-exempt investor, e.g., a pensionfund?Answer: As before, the value of the business organizedas a partnership is $400m. Also as before, the unleveredcorporation is worth $240m:$40m(1 − 40%)10%= $240m.The levered corporation is as good for the tax-exempt en-tity as the partnership, since no capital gains tax is payableon the repurchase of stock. This suggests tax-exempt insti-tutions have the strongest incentives to increase the lever-age in super-competitive projects organized as corpora-tions.Page 4Problem 18.1: Leverage ACCTG 550(10) Suppose the effective rate on debt is above 10% and the firm generatespre-tax income of $40m per year. Will taxable and tax-exempt investorsagree on how the lever the firm?Answer: For concreteness, suppose non-tax factors raisethe effective interest rate on debt issued by the firm to14%.• The elimination of corporate taxable income requiresonly $285.7m of debt since $285.7 × 14% = $40m.• A tax-exempt investor who owned all of the firmwould net $285.7.– This is better than no borrowing (i.e., $240m),even though the debt is very costly.• A taxable investor who owned all of the firm wouldnet$285.7 − 30% × (285.7 − 100) = $230.– This is worse than no borrowing (i.e., $240m)because in addition to the costly debt, thetaxable investor must pay capital gains taxes onthe repurchased stock.• The taxable investor prefers to not borrow by $10mwhile the tax-exempt investor prefers to borrow by$45.7m.• A higher-than-market rate on debt issued by the firmis an opportunity rather than a problem if it can beplaced with existing shareholders, but there are limitson interest rates that may be charged among relatedparties.Page 5ACCTG 550