Lovely Home Improvement Corporation has an all-equity capital structure and may issue $10 million of riskless debt to repurchase common stock. The CFO will consider the company’s tax rate and the creditors’ and owners’ tax rates when deciding whether to change the company’s capital structure. For each tax scenario described below, determine whether the company should change its capital structure. Explain your answer and show your work.
a) The company’s tax rate is 35% and the tax rates on personal debt and equity income are 39.6% and 31%.
b) The company’s tax rate is 35%. Individuals, with a marginal tax rate of 39.6%, hold the company’s bonds and tax-exempt foundations hold its stocks.
c) The company has depreciation tax-shields and tax credits that reduce its effective marginal tax rate to 10% and the marginal tax rates on personal debt and equity income are 37.9% and 31%.