You are the CFO of a large firm. You have heard news about the tax reform bill a

Question

You are the CFO of a large firm. You have heard news about the tax reform bill and are in the process of assessing its impact on your company. One of the main provisions in the bill is a substantial reduction in the corporate income tax rate. The textbook describes various capital structure theories such as the Modigliani and Miller (M&M) theory, the static theory of capital structure and the pecking order theory. Use these theories to analyze the impact of a reduction in the corporate income tax rate on a firm’s optimal capital structure. Then draft a memo to the CEO outlining your recommendations regarding any actions to be taken such as issue or buyback of debt as well as issue or buyback of stock.

Explanation / Answer

MEMO

TO: CEO

FROM: CFO

SUBJECT: Recommendations regarding upcoming Tax Reform Bill

This is with reference to the new Tax reform bill. The bill, among other things, introduces a substantial reduction int the corporate income tax rate. The effect of such a reduction in the tax rate will be that the tax shield that we get on interest payment on debt will now be reduced. In other words the benefits of tax savings achieved from deducting interest payments from net income will be lesser going forward.

In that case it will be prudent to rework the capital structure of our company. We should work to reduce the debt portion of the capital & replace it with more equity financing as that is less risky, and preferred now as the benefit of higher risk debt will now get reduced. So we should consider the following options:

1. Buyback of debt (Loans, debentures etc)

2. Issuance of more stock.

Looking forward to joint meetings to workout the detailed execution plan as per the above mentioned outline.

Regards

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