Question 4 (15 points)
Stata Statistical Software Inc. has reached maturity and now expects to generate earnings before interest and taxes of EBIT=$1,000,000 per year in perpetuity. That is, no future growth is expected. The firm is currently unlevered.  However, the firm intends to increase its leverage to shield additional income from taxation. The debt will pay perpetual annual coupon payments of $200,000 per year. Debt capital proceeds will be used to repurchase equity. The firm's unlevered after-tax cost of equity capital is rA=20% per year, and the after-tax cost of debt capital is rD=12% per year. Tax rates are as follows: the corporate tax rate is TC=35%, the personal tax rate on debt is TD=30%, and the personal tax rate on equity is TE=15%.  Please answer the following questions:

a. Before the debt issue, what are the expected after-tax cash flows to equity shareholders each year?  (2 points)

 

b. Before the debt issue, what is the market value of the firm?  (2 points)

 

c. After the firm issues debt, what are the expected after-tax cash flows to debtholders each year?  (2 points)

 

d. What is the market value of the debt?  (2 points)

e. What is the levered market value of the firm?  (2 points)

 

 

f. Using your answers to d. and e., what is the market value of levered equity?  (2 points)

 

g. Using your answer to f., calculate the after-tax expected return on levered equity
(rE,after-tax). (3 points)