Suppose that you are running a local coffee shop named JudyLee Coffee Corp and has an extra cash of $1,000,000. You can use this cash either to pay all outstanding debt of $1,000,000 or to repurchase its equity. If you pay all outstanding debt of $1,000,000 with this cash, your shop becomes an all-equity firm. Assume there are no transaction costs for either paying its debt or repurchase of its stock from the open market. Your shop earns the annual EBIT of $1,000,000 in perpetuity and has a corporate tax rate of 35 percent and the cost of the unlevered equity of 20 percent. The personal tax rate on interest income is 50 percent and the personal tax on the capital gain is 15 percent.
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