Oak Barrel Company has net operating income of $10 million.Further,the company has $80 million of debt outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 11 percent; and the corporate tax rate is 40 percent.What is the gain from leverage if the personal tax rate on stock income is 20 percent and the personal tax rate on debt income is 30 percent?

Question

Quizplus · Accepted Answer

PV of tax shield = $80*.40=$32 million
Value of unlevered firm = NI/r = $10 million * (1-.40)/ .11 = $6/.11 = $54.55 million
Value of levered firm = $54.55 + $32 = $86.55 million
Gain from leverage = (1 - ((1-.4)*(1-.2)/(1-.3)))*$80 = $25.14 million

Oak Barrel Company Has Net Operating Income of $10 Million