Cherokee Plastics Corporation is formed by a group of investors to manufacture household plastic products. Their initial capitalization goal is $50,000,000. That is, the incorporation have decided to raise $50,000,000 to acquire the initial assets of the company. They have narrowed down the financing mix alternatives to two:

1. all equity financing
2. $20,000,000 in debt financing and 30,000,000 in equity financing

No matter which financing alternative is chosen, the corporation expects to be able to generate a 10% annual return, before payment of interest and income taxes, on the $50,000,000 in assets acquired. The interest rate on debt would be 8%. The effective income tax rate will be approximately 50%.

Alternative 2 will require specific interest and principal payments to be made to the creditors at specific dates. The interest portion of these payments will reduce the taxable income of the corporation and hence the amount of income tax the corporation will pay. The all-equity alternative requires no specific payments to be made to suppliers of capital. The corporation is not legally liable to make distributions to its owners. If the board of directors does decide to make distribution, it is not an expense of the corporation and does not reduce taxable income and hence the taxes the corporation pays.