Capital Structure with Corporate Taxes

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JEM034 Corporate Finance (tutorial)

Petra Buzková Jitka Lešanovská

February 26, 2013

Exercise 1


The market value of a firm with $500,000 of debt is $1,700,000. The pre-tax interest rate on debt is 10% p.a., and the company is in the 34% tax bracket; the company expects $306,000 of earnings before interest and taxes every year in perpetuity. What would be the value of the firm if it was financed entirely with equity? What amount of the firm’s annual earnings is available to stockholders?

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Exercise 2


Gibson, Inc., expects perpetual earnings before interest and taxes of $1.2 mil. per year; the firm’s pre-tax cost of debt is 8% p.a., and its annual interest expense is $200,000; the company analysts estimate that the unlevered cost of Gibson’s equity is 12%; Gibson is subject to a 35% corporate tax rate. What is the value of this firm?





If there are no costs of financial distress or bankruptcy, what percentage of the firm’s capital structure would be financed by debt?

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Exercise 3
The Holland Company expects perpetual EBIT of $4 mil. per year; the firm’s after-tax, all-equity discount rate (r0) is 15%; company is subject to the tax rate of 35%; the pre-tax cost of the firm’s debt capital is 10% p.a., and the firm has $10 mil. of debt in its capital structure.  What is Holland’s value?  What is Holland’s cost of equity (re)?  What is Holland’s WACC? 

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There is possibility for up to 3 students to get extra points for active participation in tutorial 1:  Student 1: Problem 1  Student 2: Problem 2

 Student 3: Problem 3
 If you want to book your exercise in advance,

please send an email to both tutors, i.e. to j.lesanovska@centrum.cz and buzkova.p@seznam.cz  The subject of an email should be: Corporate Finance - exercise presentation

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