Company ABC is expected to have EBIT (earnings before interest and tax) of $1 million per year forever and the market value of the shares of the company currently is $8 million. At present the company has no debt. ABC plans to raise $3 million of perpetual debt at 8%, which will be risk-free, and use that to buy-back shares. (That means, an 8% interest will have to be paid on the debt in every year, forever, and the principal will never be paid back.) The tax rate of ABC is 20%.
a) What will be the value of equity after the change in capital structure of ABC?
b) After the change in capital structure, suppose that due to a tax rate hike by the government the tax rate for ABC goes up from 20% to 30%. Please answer in words, how would change in tax rate affect the value of equity of ABC?