Eccles Inc., a zero growth firm, has an expected EBIT of $120,000 and a corporat

Question

Eccles Inc., a zero growth firm, has an expected EBIT of $120,000 and a corporate tax rate of 35%. Eccles uses $500,000 of 12% debt, and the cost of equity to an unlevered firm in the same risk class is 16%.

a. What is the value of the firm according to Modigliani-Miller with corporate taxes?

b. What is the firm's cost of equity?

c. Assume that the firm's gain from leverage according to the Miller Model is $130,000. If the effective personal tax rae on stock income is Ts=25%, what is the implied personal tax rate on debt income?

Explanation / Answer

( a)

VALUE OF UNLEVERED FIRM = EBIT(1-TAX RATE)/ke = 120000(1-0.35)/0.16 = $487500

VALUE OF LEVERED FIRM = VALUE OF UNLEVRED FIRM + DEBT(TAX RATE)

VALUE OF LEVERED FIRM = $487500 + ($500000)(0.35) = $662500

THEREFORE VALUE OF EQUITY = $662500 - $50000 = $162500

(b)

ke = k0 + (k0-kd)(D/S)(1-TAX RATE) = 16% + (16%-12%)(500000/162500) (1-0.35) =16% + 8% = 24%

COST OF EQUITY = 24%

(c )

GAIN FROM LEVERAGE = 130000

FORMULA = GAIN FROM LEVERAGE = [1 - ((1- TAX RATE)(1-Ts)/(1-Td))] D

130000 = [1 - ((1-0.35)(1-0.25)/(1-Td))] 500000

130000/500000 = 1 - ((0.65)(0.75)/(1-Td))

0.26 = 1 - (0.4875/(1-Td))

(0.4875/(1-Td)) = 1 -0.26

(0.4875/(1-Td)) = 0.74

1-Td = 0.4875/0.74 = 0.6588

Td = 1- 0.6588 = 0.3412 = 34.12% IMPLIED PERSONAL TAX RATE ON DEBT

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