1. ABC INC. is currently all equity financed, has EBIT of $2 million, and is in the 34% tax bracket. It is considering a plan to convert $4 million of equity into debt paying 10% interest. Assume that the firm follows a 100% dividend payout policy, and the unlevered cost of equity is 15%.

a. Compare the total after-tax cash flows to investors (both shareholders and debtholders) under the two financial structures (all-equity and levered).

b. If investors pay personal taxes on interest and dividend income at 40%, which financial structure would make the investors better off between the current capital structure and the proposed capital structure? How much does the firm value change if the proposed capital structure is taken?