1. The market value of an unlevered firm is 400M and its debt value is 100M. The corporate tax rate is 40%, the taxes on the equity earnings is 35% and the taxes of the debt earnings are 40%.
1. What is the value of the firm? And the value of its equity?
2. If the firm buys back shares with the proceedings of a debt issue of 200M, what is the new value of the firm? Is it a good idea for firms to increase debt in this case?
3. Suppose the government wants to change the tax regime to alleviate charges to shareholders, so that now corporate taxes are 25%, the personal tax on dividends from equity are 10%, and the personal tax on interest from debt are 45%. If the company issues the 200M in debt under the new tax regime, what is the new value of the firm? Is it a good idea for firms to increase debt in this case? Compare it to its value in case b) and explain.