Question 6 (14 marks)

a) You, as an Australian resident, hold shares in FIN222 Ltd which you purchased 2 years ago for $30 per share. They are now selling for $37 per share. You have a marginal tax rate of 37% while the corporate tax rate is 30%. Under the imputation tax system, would you prefer to receive $7 special dividends or sell the shares and benefit from capital gains? Show all your workings.

b) FIN222 Ltd carries $30 million in debt. The market value of debt matches its book value of $30 million. The firm expects to generate $15 million per year in free cash flows next year and these free cash flows are expected to grow at 4% per year in perpetuity. Each year, FIN222 Ltd is expected to pay out 60% of its free cash flows as dividends. The cost of debt is 9% before tax and the cost of equity to the firm is 13%. Corporate tax rate is 30%. Assume that investors can utilise 70% of the franking credits paid by the firm.

(I) Assume a classical tax system and calculate the market value of equity.

(ii) Assume a classical tax system and calculate the WACC.

(iii) Assume an imputation tax system and calculate the market value of equity.

(IV) Assume an imputation tax system and calculate the WACC.