Question

Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. Assume that the firm's gain from leverage according to the Miller model is $126,667.
1. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?
a. 16.4%b. 18.2%c. 25.0%d. 20.2%e. 22.5%

Answer 1

Answer:

implied personal tax on debt income = 25%

so correct option is c. 25.0%

Explanation:

given data

expected EBIT = $100,000

corporate tax rate T = 30%

debt amount = $500,000

debt rate = 12%

cost of equity same risk Ru = 16.0%

to find out

implied personal tax rate on debt income

solution

we get here value of unlevered firm that is express as

value of unlevered firm = $\frac{EBIT(1-T)}{Ru}$   ..........1

put here value

value of unlevered firm Vu = $\frac{100000(1-0.30)}{0.16}$

value of unlevered firm Vu = $437500

and

now we get here value of levered firm that is express as

value of levered firm = value of unlevered firm + tax × debt    ..........2

value of levered firm = $437500 + $500000 × ( 0.30)

value of levered firm = $587500

and

now we get implied personal tax on debt income

implied personal tax on debt income = 1 -  $\frac{126667}{150000*(1.12)}$

implied personal tax on debt income = 0.2460

implied personal tax on debt income = 25%

so correct option is c. 25.0%