Question

4. (Tax Benefits) January 2020, Starbucks considers moving to Delaware from Seattle to reduce its marginal tax rate from current 21% to 13%. Starbucks' debt-to-equity ratio equals 0.5 and its current debt cost of capital is 6%. (a) Compute by how much this would change WACC. (b) Suppose Starbucks abandons the idea of relocation and instead decides to call $5 billion of permanent debt and replace it with convertible bonds of the same value. If the economy is strong in April, then convertible bonds convert to equity this year. If the economy in April is weak, then they remain on the balance sheet as permanent debt. Both states of the economy are equally likely. By how many would this restructuring change the present value of tax shield?

Answer 1

a.

WACC( weighted average cost of capital)=Debt equity ratio * debt cost of capital * (1- tax Rate)

therefore

Situation A i.e at Delaware(0.5*0.06*(1-.21)=.0237

Situation B i.e. at Seattle(0.5*0.06(1-.13)=0.0261

therefore change in WACC= 0.0237-0.0261 i.e 0.0024 or 2.34%

b.

Well in situation A i.e call for $ 5 billion of permanent debt & replace it with convertible bonds of the same value,

If the economy is strong in April, then bonds might change to equity. If such situation arise , it would be profitbale for the company

as call for permanent debt will increase the cost of finance which will ultimately reduce the tax liability, and further converting the same into eqity with the

help of copnvertable bond which will be a win- win situation for the company

In the other situation if the economy is down , & debt remians permanently in the balance sheet then

it will reduce the tax liability as cost of finance will get increase , however no other benefit will be achieved