A. The firms of the economy produce $100,000 per year in pre-tax and interest cash flows in perpetuity. This production is riskless. The corporate tax rate is 30%. There are two groups of investors. The first group of investors, group A, is taxed at a 40% rate at the personal level on interest income. This group has a wealth of $225,000. The second group of investors, group B, is taxed at 20% on 6 bond income. This group has a wealth of $200,000. Neither group is taxed on stock income. Both groups of investors need a 14% after (personal) tax return on investments, and both groups of investors are risk neutral (i.e. they discount all level of risky expected after-tax cash flows at the same rate).
i. Verbally characterize the optimal (tax minimizing) capital structure for the economy (i.e. what type of securities should each group hold — bonds or stock?)
ii. Suppose all the groups paid taxes on stock income of 15%. How does the equilibrium optimal capital structure change?
B. Your firm needs external funding for capital projects. The yield on your corporate bonds appears to be 8%. Your corporate marginal tax rate is is 35%. Similar risk Tax-Exempts appear to yield 5.5%. Is this an appropriate time for a debt issue?
i. state your conclusion, assumptions, and rationale