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The initial investment required to incorporate a company is $ 6,000,000. The expected earnings before interest and taxes are $ 1,500,000 per year, indefinitely. In
The initial investment required to incorporate a company is $ 6,000,000. The expected earnings before interest and taxes are $ 1,500,000 per year, indefinitely. In addition, the tax rate is estimated at 35%. All after-tax profits will immediately be paid out as dividends. To raise the $ 6,000,000, the leaders consider the following two possibilities:
- Issue common shares for $ 6,000,000 (1,500,000 shares which earn $ 4 net per share). The rate of return required by shareholders would be 10%.
- Borrow $ 4,000,000 at an annual interest rate of 8% and issue 500,000 shares which earn $ 4 net per share. It is assumed that the loan is permanent.
Questions :
1) According to Modigliani and Miller, if we only take into account the corporate tax, what will be,
for each financing opportunity, the market value of the business?
2) According to Modigliani and Miller, if one considers only the corporate tax, what rate of return should the shareholders of the company charge if the second financing opportunity is chosen?
3) According to Miller (1977), if we take into account the corporate tax and taxes paid on equity income (at 10%) and on interest income (at 15%) by investors, what will the market value of the business be if it is financed by stocks and bonds? Compare the tax advantage associated with debt in this case with the tax advantage obtained using the model of Modigliani and Miller (1963). Explain (maximum 5 lines).
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