Let’s walk through an example and compute your post-tax returns. Suppose $2 million of your investment is structured as debt and the remaining $8 million is equity. What happens each year after the company is set up? Well, using the $4 million EBIT, the company will first pay $2 million 50% = $1 million interest to you (as a debt investor). Then, on the remaining $4 $1 = $3 million of EBIT, the company pays corporate taxes of $3 20% = $0.6 million and is left with $2.4 million, which will be paid out to you (the equity holder) as dividend. Income Statement EBIT 4 -Interest expense 1 -Corporate taxes .6 = Net income of 2.4 million Therefore, the total returns to you (as an investor) is $1 million in interest and $2.4 million in dividends, which is a total of $3.4 million.4 Uncle Sam collected $0.6 million. The company will go bankrupt if its EBIT is strictly less than interest expense. Assume that all value is destroyed in case of bankruptcy (you lose all your investment), so you will avoid bankruptcy at all Your goal is to maximize your post-tax investment return. What is the optimal choice of debt-and-equity mix in your investment? And what would your total investment return be?
At this point, you may be confused why calling part of your in- vestment debt or equity makes a difference. Let’s walk through an example and compute your post-tax returns. Suppose $2 million of your investment is structured as debt and the remaining $8 million is equity.
What happens each year after the company is set up? Well, using the $4 million EBIT, the company will first pay $2 million 50% = $1 million interest to you (as a debt investor). Then, on the remaining $4 $1 = $3 million of EBIT, the company pays corporate taxes of $3 20% = $0.6 million and is left with $2.4 million, which will be paid out to you (the equity holder) as dividend.
Income Statement
EBIT 4
-Interest expense 1
-Corporate taxes .6
= Net income of 2.4 million
Therefore, the total returns to you (as an investor) is $1 million in interest and $2.4 million in dividends, which is a total of $3.4 million.4 Uncle Sam collected $0.6 million.
- The company will go bankrupt if its EBIT is strictly less than interest expense. Assume that all value is destroyed in case of bankruptcy (you lose all your investment), so you will avoid bankruptcy at all
Your goal is to maximize your post-tax investment return. What is the optimal choice of debt-and-equity mix in your investment? And what would your total investment return be?
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