16.11 Fortune Enterprises (FE) is an all-equity firm that is considering issuing $13,500,000 in 10-percent debt. The firm will use the proceeds of the bond sale to repurchase equity. FE has a 100-percent payout policy. Because FE is a nongrowth firm, its earnings and debt would be perpetual. FE’s income statement under each of the financial structures is shown below.

a. If the personal tax rate is 30 percent, which plan offers the investors the higher cash flows? Why?

b. Which plan does the IRS prefer?

c. Suppose stockholders demand a 20-percent return after personal taxes. What is the value of the firm under each plan?

d. Suppose TS = 0.2 and TB = 0.55. What are the investors’ returns under each plan?

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All Equity Debt EBIT Interest $3,000,000 $3,000,000 0 1,350,000 EBT 3,000,000 1,650,000 Taxes (Tc = 0.4) Net income 1,200,000 660,000 $1,800,000 $ 990,000