Question
Consider the following example: Suppose a large, multibillion-dollar corporation called Global Systems has only 10% debt in its capital structure and purchases an asset for
Consider the following example: Suppose a large, multibillion-dollar corporation called Global Systems has only 10% debt in its capital structure and purchases an asset for US$10,000. Global Systems could easily take on much more debt if it wanted to. The asset purchased is very risky, and a firm owning only this asset could borrow only US$2,000 to finance the asset, i.e., the asset has a debt capacity of 20%. Assume that the debt is perpetual, the interest rate on debt is 5% and the marginal corporate tax rate is 40%. Therefore, the PV of the tax shield is US$800 (using the debt interest rate to discount the debt tax shield): PV with 20% debt = (Tc * rd * D) /r = (0.4 * 0.05 * 2,000) / 0.05 = US$800 After looking at these numbers, the Global Systems analyst, who is managing the asset says, Let us issue debt to pay for US$5,000 of the asset and stock to finance the remaining US$5,000. If we do this, the project will be worth more to us. Changing only the amount of debt and keeping all other assumptions constant, he calculates the PV of the tax shield as follows: PV with 50% debt = (Tc * rd * D) /r = (0.4 * 0.05 * 5,000) / 0.05 = US$2,000 What do you think of this analyst's logic?
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