1. Tax Shields
River Cruises is all-equity-financed with 55,000 shares. It now proposes to issue $300,000 of debt at an interest rate of 12% and to use the proceeds to repurchase 30,000 shares. Suppose that the corporate tax rate is 35%. Calculate the dollar increase in the combined after-tax income of its debtholders and equityholders if profits before interest are:
Increase in Cash Flow for each of the following values:
a) $80,000
b) $105,000
c) $180,000
2. A bank would like to lend to potential entrepreneurs in a village, but cannot distinguish between them. Suppose there are three types of entrepreneurs: a fraction p of the population are good entrepreneurs who always repay loans; a fraction q of the population are moderate entrepreneurs, who repay loans half the time; and the remaining fraction (1-p-q) are bad entrepreneurs who never repay loans. Each would like a loan of $10. Assume the bank has access to funds at a national interest rate of r = 0.
(a) suppose thed bank lends to an arbitrary entrepreneur in the village at some interest rate i. what is the expected amount of retirement it will receive on the $10 loan?
(b) In order to break even on average at which interest rate, i, should the bank lend to a borrower?
(c) interpret, in words, how i depends on p, q and why.