14. Now, assume that the corporate tax rate is 30%. As above, Nike has a project

Question

14. Now, assume that the corporate tax rate is 30%. As above, Nike has a project that will produce $200 as EBIT if the economy is strong and $50 if the economy is poor. This time, Nike raised $30 by issuing debt and $40 by issuing equity. Nike issues this amount of debt at the risk-free rate. The market premium and the risk-free rate are still 7% and 5%, respectively (a) Check that Nike can indeed issue $30 of debt at the risk-free rate without facing bankruptcy by taking into account the fact that the tax rate is not zero. (b) Calculate the after-tax payments to the equity holders. (c) What's the expected return Eeqired by the equity holders? What's the equity beta? (d) Suppose you are a single investor of Nike, who holds all the equities and bonds issued by Nike. Then, by definition, your return rA satisfies (E + D)(1+1)=E(1 +Tg) + D(1 +.) = EBIT × (1-t)+1TpD. where is the tax rate, E is the market value of equity and D is the market value of debt in this example, E 40 and D 30. Now, compute E[rA for Nike (e) By simple algebra, the above relation implies that EBITx (1-1) E +D So, to calculate E D (firm value or the total amount of funds that can be raised), we can use EBiTx(1-t) WGcc where T7 DI E +D instead of using EBIT x (1-r) + trD Now, compute E[rwacc] for Nike, using formula (2). Check whether relation (1) indeed holds. Here, rwacc is commonly called the weighted average cost of capital (WACC) Now, consider New Balance. This firm also has a project that will produce $200 as EBIT if the economy is strong and $50 if the economy is poor. But the entrepreneur of New Balance is very conservative. So, she wants to raise only $10 by issuing debt. (f) Suppose investor A is a single investor of Nike and investor B is a single investor of New (g) Your answer in (f) implies which company can raise more funds? In other words, the amount (h) Who requires a higher expected return between investor A and investor B? In other words, Balance. Who will earn more payoffs between investor A and investor B? of funds that New Balance can raise from equity is more than, equal to, or less than $60? which one is larger between the WACC for Nike and the WACC for New Balance?

Explanation / Answer

a. yes nike can issued $30 of debt on risk free return without facing bankruptcy.

b. after tax payment if economy is strong = $ 138.95 and if poor economy = $ 33.95.
Calculation made as under

c. expected rate of return by the equity holders is 12% & Equity Beta is 1 which was calculated as follows
Market premium is 7% and risk free return is 5 % by puting the values of both in CAPM Capital Asset Pricing Model where Market premium is market rate - risk free rate.

d.

Particulars Strong Economy Poor Economy EBIT ( Given ) $ 200 $ 50 Less - Interest ( $1.5 ) ($1.5 ) EBT ( Earning before tax ) $ 198.5 $ 48.5 Less - Tax @ 30% ($ 59.55 ) ( $ 14.55) EAT ( Earning after tax ) $ 138.95 $ 33.95

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