Fortune Enterprises is an all-equity firm that is considering issuing $13.5 million of perpetual debt. The interest rate is 10%. The firm will use the proceeds of the bond sale to repurchase equity. Fortune distributes all earnings available to stockholders immediately as dividends. The firm will generate $3 million of earnings before interest and taxes (EBIT) every year into perpetuity. Fortune is subject to a corporate tax rate of 40%. Suppose the personal tax rate on interest income is 55%, and the personal tax rate on equity income is 20%.

a. What is the annual after-tax cash flow to equity holders under each plan?

Unlevered Levered

EBIT $3 million $3 million

Interest $0 million $1.35 million =$13.5 m*0.1

EBT $3 million $1.65 million

Corporate Taxes $1.2 million $0.66 million

Net Income $1.8 million $0.99 million

b. What is the annual after-tax cash flow to debt holders under each plan?

c. Does debt still have an advantage over equity in this case, and why?