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IF THE ONLY VIOLATION OF THE M&M ASSUMPTIONS IS THAT INVESTORS FACE ONE TAX RATE

IF THE ONLY VIOLATION OF THE M&M ASSUMPTIONS IS THAT INVESTORS FACE ONE TAX RATE

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Author: Christine Farr
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1. If the only violation of the M&M assumptions is that investors face one tax rate for interest income and another tax rate for equity income, what is the implication for the optimal capital structure of a corporation?
2. A corporation has the following balance sheet (liabilities side)
Current liabilities 2,000
Long-term debt 5,000
Preferred stock 2,000
common stock 8,000
retained earnings 3,000
Currently, the riskless interest rate is 8%; the corporate tax rate is 50%; the current price of a share of common stock is $20; and dividends have been level at $1 per share per year for many years.
Recently, company executives have considered expanding the existing business by acquiring a competitor. To do so, they must caluculate the WACC of the firm and estimate the NPV of the acquisition. Because the acquisition is of the same risk as the firm, the WACC (unlevered equity cost) can be used.
A financial executive has used the following procedure to calculate the WACC. Debt and preferred cost are fixed claims offering a fairly secure constant return, and so their before tax cost is assumed to equal the riskless rate. The dividend yield has held constant at about 5%; so this is used as the cost of new and retained equity (common plus reatined), and 10% current liabilities. Current liabilities are assumed to be costless; therefore the WACC is 4.55%.
Comment of this procedure:


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