Question
Use Miller Model to answer this question. Happy Company is currently all equity financed and generates a constant EBIT per year that is expected to
Use Miller Model to answer this question.
Happy Company is currently all equity financed and generates a constant EBIT per year that is expected to continue in perpetuity. The unlevered cost of equity for the company is 10%. The value of the firm without any debt is $200,000. The corporate tax rate is 20%, while investors are taxed at 30% on equity income and 60% on bond income.
(a) Happy Company issues a perpetual bond with a market value of $100,000. Assume that there is no financial distress cost.
(1) What is the value of the gain/loss from leverage for the firm?
[Note: You must indicate clearly that this is a gain or loss from leverage.]
(2) What is the value of the firm with the debt of $100,000?
(3) Should the firm borrow any debt with the existing corporate and personal tax rates? Briefly explain your answer in one sentence.
(b) All of the above information remains unchanged except for the personal tax rate on bond income. Assume that the personal tax rate on bond income is 44% now.
- What is the value of the firm if it issues the same amount of debt (i.e., $100,000) now?
- Is there any gain/loss from leverage now? If yes, what is the value of the gain/loss from leverage?
- Is this case consistent with Proposition I of Modigliani and Miller Model No Taxes Case or Modigliani and Miller Model with Corporate Taxes Case? Is the capital structure of the firm relevant to the value of the firm, that is, does the capital structure affect the value of the value for this case now? (Just answer YES or NO.)
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