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The CFO of Microsoft is considering a leveraged recapitalization pitched by Goldman Sachs.
The CFO of Microsoft is considering a leveraged recapitalization pitched by Goldman Sachs. Under the plan, Goldman would underwrite the flotation of a $10 billion bond, with a maturity of 20 years, with the coupon rate equal to the risk-free rate on Treasury bonds, rf =4%.
Microsoft's debt is viewed by the markets as risk free. At the end of 20 years, Microsoft will "roll- over" the bond. That is, at maturity it will issue a new bond with identical provisions to the first bond. The $10 Billion received for the new bond will be used to cover the principal payment ($10 Billion) due under the terms of the first bond. This process will be repeated every 20 years. In this way, Microsoft's interest expense into perpetuity will be identical to that on a consol bond with an annual coupon of $400 million.
Microsoft's estimated corporate tax rate is 36%. Under the terms of the deal, Goldman agrees to place all future bond issues for free. However, it demands up-front compensation for its services. In particular, it demands a fee equal to f times the market price of the first bond issued.
a) What is the maximum value of f such that the deal is still worth doing from the perspective of Microsoft's shareholders?
b) What is the value of tax shield from the deal?
c) Extra credit. Now assume that firm's profits are paid out to shareholders as dividends and the tax rate that shareholders pay on dividend income is estimated to be 15%. Note that, under this assumption, proceeds from issuing the bond will be taxed when paid as dividends. However, further dividends will be reduced by the interest payments and therefore shareholders should pay less dividend income tax in perpetuity. What is the maximum value of f ?
