You are engineering an LBO of Acme Industries, an industrial bottle maker. After the LBO, the firm will be financed 90 percent with debt and 10 percent with equity. Fred Farber, the CEO, will own 30 percent of the shares. Fred thinks the proposed capital structure is too highly levered and points out that, in the first few years, the firm will not be able to use all its debt tax shields.

Initially, the interest payments are $400 million per year and EBIT is only $300 million per year.

However, EBIT is projected to increase 20 percent per year for the next five years.

Give Fred a pure tax argument that supports the high level of debt. Take into account his personal taxes as well as corporate taxes. Does your tax argument depend on whether Fred wants to dilute his ownership of the company in the future?

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