16.14 The EXES Company is assessing its present capital structure and that structure’s implications for the welfare of its investors. EXES is currently financed entirely with common stock, of which 1,000 shares are outstanding. Given the risk of the underlying cash flows (EBIT) generated by EXES, investors currently require a 20-percent return on the EXES common stock. The company pays out all earnings as dividends to common stockholders.

EXES estimates that operating income may be $1,000, $2,000, or $4,200 with respective probabilities of 0.1, 0.4, and 0.5. Assume the firm’s expectations about earnings will be met and that they will be unchanged in perpetuity. Also, assume that the corporate and personal tax rates are equal to zero.

a. What is the value of EXES Company?

b. The president of EXES has decided that shareholders would be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $7,500 of debt at an interest rate of 10 percent. He will use the proceeds to repurchase 500 shares of common stock.
i. What will the new value of the firm be?
ii. What will the value of EXES’s debt be?
iii. What will the value of EXES’s equity be?

c. Suppose the president’s proposal is implemented.
i. What is the required rate of return on equity?
ii. What is the firm’s overall required return?

d. Suppose the corporate tax rate is 40 percent.
i. Use the Modigliani-Miller framework that includes taxes to find the value of the firm.
ii. Does the presence of taxes increase or decrease the value of the firm? Why?
iii. Verbally explain how the presence of bankruptcy costs would change the effect of taxes on the value of the firm, if at all.

e. Suppose interest income is taxed at 40 percent while the effective tax on returns to equityholders is zero. Assume that the introduction of the personal tax rate does not affect the required return on equity.
i. What is the value of EXES in a world with personal taxes?
ii. Under the Miller model, what will happen to the value of the firm as the tax on interest income rises?