Problem
Leverage
Emerald is an all equity financed company, which is valued at £250 million. The firm's shares are expected to produce a return of 21 percent. The government announces the introduction of a corporate tax rate of 35 percent. The company has decided to modify its capital structure with a target debt-equity ratio of 25 percent. The company has been told that any borrowings it makes will attract a rate of 9 percent.
Task
I. In the time before taxes were introduced, calculate the return on equity of Emerald before and after the restructuring.
II. Explain why the return on equity has changed as a result of restructuring, although there are no taxes.
III. Now, assume that the corporate tax rate of 35 percent is in force, capital gains tax is zero and the personal income tax rate is 45 percent. What is the value of Emerald before the restructuring? What is its value after?