Review4 - ECONOMICS 448, Review 4 16.12 The general...

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ECONOMICS 448, Review 4 16.12 The general expression for the value of a leveraged firm in a world in which Ts=0 is V L = V U +[1-(1-T C )(1-T S )/(1-T B )]B-C(B) where: V U = Value of an unlevered firm T C = Efficient corporate tax rate for the firm T B = Personal tax rate of the marginal bondholder B = Debt level of the firm C(B) = Present value of the cost of financial distress for the firm as a function of its debt level. [Note: C(B) encompasses all non-tax-related effects of leverage on the firm’s value] Assume all investors are risk-neutral. a. In their no-tax model, what do Modigliani and Miller assume about T C , T B and C(B)? What do the assumption imply about a firm’s optimal debt-equity ratio? b. In their model that includes taxes, what do Modigliani and Miller assume about T C , T B and C(B)? What do these assumptions imply about a firm’s optimal debt-equity ratio? c. Assume that IBM is certain to be able to use its interest deductions to reduce its corporate tax bill. What would the change in the value of IBM be if the company issued $1 billion in debt and used the proceeds to repurchase equity? Assume that the personal tax rate on bond income is 20 percent, the corporate tax rate is 34 percent, and the cost of financial distress is zero. d. Assume that USX is virtually certain not to be able to use interest reductions. What would the change in the value of the company be from adding $1 of perpetual debt rather than $1of equity? Assume that the personal tax rate on bond income is 20 percent, the corporate tax rate is 35 percent, and the cost of financial distress is zero. e. For companies that may or may not be able to use the interest deduction, what would the change in the value of the company be from adding $1 of perpetual debt rather than $1 of equity? Assume that the personal tax rate on bond income is 20 percent, the corporate tax rate is 35 percent, and the costs of financial distress are zero. Also assume the probability of using the incremental deduction is 65 percent.
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16.14: The EXES Company is assessing its present capital structure and that
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Review4 - ECONOMICS 448, Review 4 16.12 The general...

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