1 suppose t e t t d cpn and r d are 0 20 0 50m m

Info icon This preview shows pages 15–17. Sign up to view the full content.

View Full Document Right Arrow Icon
(1) Suppose T e , T, T d , CPN, and r d are 0%, 20%, 0%, $50M (M = million), and 5%, respectively. What is α ? What is G L ? How does this answer compare with using the G L equation for the corporate tax view of capital structure? (2) Suppose T e , T, T d , CPN, and r d are 0.10%, 20%, 0.15%, $50M (M = million), and 5%, respectively. What is α ? What is G L ? How does this answer compare with using the G L equation for the corporate tax view of capital structure? How do you explain the difference? (3) Assume that values for all other variables are the same as in (2) with the exception that the personal tax rates on equity and debt income are equal. What can we say about α ? What can we say about G L ? (4) Is the equation, G L = [1 – α ]D, complete? For example, exactly what variables are missing from this equation? ANSWER (1): Solving for α , we have: α = (1 – T e )(1 – T) / (1 – T d ) = (1 – 0)(1 – 0.3) / (1 – 0) = (1 – 0.3) or 0.7 . G L = [1 – α ]D = [1 – α ](1 – T d )CPN / r d = (1 – 0.7) (1 – 0.15)$50M / 0.05 = (1 – 0.15)$300 million . This is similar to the answer using the corporate tax view of capital structure where we have: G L = TD = T(1 – T d )(CPN / r d ) = 0.3($50M / 0.05) = 0.3($1 billion) = $300 million . Thus, the answer for G L for the corporate tax view is like that for the personal tax except that $300 million is multiplied by (1 – T d ), which takes into account debtholders pay taxes. The similarity in answers results because (1 – α ) reduces to T when T e = T d . ANSWER (2): Solving for α , we have: α = (1 – T e )(1 – T) / (1 – T d ) = (1 – 0.1)(1 – 0.2) / (1 – 0.15) = (0.9)(0.8) / (0.85) = 0.8470588 or about 0.8471 . G L = [1 – α ]D = [1 – α ](1 – T d )CPN / r d = (1 – 0.8470588)(1 – 0.15)$50M / 0.05 = $130 million . This is the not same answer as using the corporate tax view of capital structure where we have: G L = TD = T(CPN / r d ) = 0.2($50 million / 0.05) = 0.2($1 billion) = $200 million . The answer disagrees because we consider personal taxes on equity and debt income. The $200 million falls to $130 because of the overall effect of personal tax rates. In particular, the personal tax rate on debt income is greater than that on
Image of page 15

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
equity income which helps to explain some of the difference. Most of the difference can be explained by the fact debtholders now pay taxes. Note that even without considering the impact of (1 – α ), we have: (1 – T d )CPN / r d = (1 – 0.85)$50M / 0.05 = $850 million. For the corporate tax view, this value would be $1 billion because debtholders do not pay personal taxes. ANSWER (3): If personal tax rates are equal (T e = T d ), then α = (1 – T e )(1 – T) / (1 – T d ) = (1 – T) = (1 – 0.2) = 0.8 . G L = [1 – α ]D = [1 – α ](1 – T d )CPN / r d = (1 – 0.8)(1 – T d )$50M / 0.05 = (1 – T d )$200 million . For the corporate tax view, we have: G L = TD = T(CPN / r d ) = 0.2($50M / 0.05) = 0.2($1 billion) = $200 million . Thus, the answer for G L for the corporate tax view is like that for the personal tax except that $200 million is multiplied by (1 – T d ), which takes into account the situation that debtholders now pay taxes. The similarity in answers results because (1 – α ) reduces to T when T e = T d .
Image of page 16
Image of page 17
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern