Question

) Lovely Home Improvement Corporation has an all-equity capital structure and may issue $10 million of . The CFO will consider the company's tax rate and the creditors' and 5. (8 points riskless debt to repurchase common stock ners' tax rates when deciding whether to change the company's capital structure. For each tax scenario described below, determine whether the company should change its capital structure. Explain your answer and show your work. ow a. (2 points) The company's tax rate is 35% and the tax rates on personal debt and equity income are 39.6% and 31%. b. (2 points) The company's tax rate is 35%. Individuals, with a marginal tax rate of 39.6%, hold the company's bonds and tax-exempt foundations hold its stocks. (2 points) The company has depreciation tax-shields and tax credits that reduce its effective marginal tax rate to 10% and the marginal tax rates on personal debt and equity income are 37.9% and 31%. (2 points) The company's marginal tax rate is 34% and the marginal tax rate on personal debt and equity income is 28%.

Answer 1

a. If the company issues debt worth $10 million with the tax rate being 35%, the company shall be able to enjoy a tax shield of 35% of the interest paid on the debt. At the same time, the creditors will be liable to tax at the rate 39.6% of interest amount received by them.

The shareholders (owners) will save a tax amounting to 31% of the dividend that they would have received if the common stock was not repurchased.

Considering the above scenario that the creditors have to pay high tax, the company may not consider the option of issuing the debt.

b. Now, since the company's bonds are held by tax-exemption stocks, the creditors will be exempted from paying tax on the interest received by them, other things remaining the same as in (a) above, the company may go ahead with the option, considering the favourable case available to the creditors.

c. The company's marginal tax rate has decreased to 10%, due to which there will be tax shield of 10% of the interest paid. But since the rates for debt and equity are much higher, the company may choose to not follow the option.

d. Here the company will get a tax shield of 34%, and also the rates on debt and equity income are lower (28%), the company may go ahead with the option.