Suppose that XYZ Corporation
- operates in a perfect capital market,
- faces a 40% corporate tax, and
- has a current asset value of $1,000.
Management expects operating earnings (i.e., earnings before interest and taxes) of $200 in the coming year.
- Calculate the total expected income available to the suppliers of capital for the following three capital structures:
- Capital structure 1: 100% equity
- Capital structure 2: 70% equity and 30% debt with an annual interest of 10%
- Capital structure 3: 30% equity and 70% debt with an annual interest of 10%
- What”s the optimal capital structure for this company? Assume that the annual interest of 10% applied to any amount of debt.
- If an individual income tax is introduced into this market and income tax on bond interest is much higher than that on dividends, how will the optimal capital structure of this company be affected and why?