Question

4. Value and Debt Consider the following model: (1 -T) Veidt Industries (VI) has one million shares outstanding with a market price of $13.5 per share. VI's permanent debt is $6.25 million. The company and investors pay tax at the following rates Corporate income: 30% . Personal income: T-10% (equity) ·Ti-25% (interest) Although investors expected VI to maintain its existing debt permanently, management plans to announce that VI will repay all of its debt using the proceeds of an equity issue. Management thinks that "unlevering" will boost VI's share price.

Please step by step and thanks for occupying your time.

Answer 1

a. VL = E + D = 1,000,000 *13.5 + 6,250,000 = 19,750,000

b. Now, with The equation VL = VU +[ 1- (1-Tc)(1-Te)/(1-Ti)]* D

19,750,000 = Vu + [1-(1-0.3)(1-0.1)/(1-0.25)]*6,250,000

19,750,000 = Vu + 1,000,000

Vu = 18,750,000

c. No, the management was not correct. Paying up all the debt will result in reduction in the Value of the firm by 1,000,000. This is because of the tax advantage of debt. The risk of investing in the firm becomes lower and hence the return for shareholders will also be less due to lower risk.

d. Number of shares Outstanding = 6,250,000/13.5 + 1,000,000 = 1,462,963 shares

e. The government should try to make (1-Tc)(1-Te)/(1-Ti) = 1

(1-Tc)*(1-0.1)/(1-0.25) = 1

(1-Tc) *1.2 = 1

1-Tc =1/1.2

Tc = 1-0.83333

Tc = 0.1667 = 16.67%

The government should reduce the corporate tax rate to 16.67%