Questions: Use the following to answer questions 22-23: Wigdor Manufacturing is currently all equity financed, has EBIT of 2 million, and is in the 34% tax bracket. Louis, the company's founder, is the lone shareholder. If the firm were to convert 4 million of equity into debt at a cost of 10%, what 22. would be the total cash flow to Louis if he holds all the debt? Compare this to Louis' total cash flow if the firm remains unlevered. Assume no personal taxes.

To answer the question, we need to compare the total cash flow to Louis under two scenarios: when the firm remains unlevered and when the firm converts $4 million of equity into debt at a cost of 10%.

• EBIT (Earnings Before Interest and Taxes): $2,000,000
• Tax rate: 34%

Since the firm is unlevered, there is no interest expense. Therefore, the taxable income is equal to EBIT.

Taxable Income = EBIT = $2,000,000

Taxes = Taxable Income * Tax Rate = $2,000,000 * 34% = $680,000

Net Income = Taxable Income - Taxes = $2,000,000 - $680,000 = $1,320,000

Since Louis is the lone shareholder, the total cash flow to Louis is the net income.

Total Cash Flow to Louis (Unlevered) = $1,320,000

• Debt: $4,000,000
• Interest rate on debt: 10%
• EBIT: $2,000,000
• Tax rate: 34%

First, we need to calculate the interest expense on the debt.

Interest Expense = Debt * Interest Rate = $4,000,000 * 10% = $400,000

The taxable income is now reduced by the interest expense.

Taxable Income = EBIT - Interest Expense = $2,000,000 - $400,000 = $1,600,000

Taxes = Taxable Income * Tax Rate = $1,600,000 * 34% = $544,000

Net Income = Taxable Income - Taxes = $1,600,000 - $544,000 = $1,056,000

Now, we need to add the interest income that Louis would receive from holding the debt.

Interest Income = Interest Expense = $400,000

Total Cash Flow to Louis (Levered) = Net Income + Interest Income = $1,056,000 + $400,000 = $1,456,000

• Total Cash Flow to Louis (Unlevered): $1,320,000
• Total Cash Flow to Louis (Levered): $1,456,000

Conclusion: The total cash flow to Louis if the firm remains unlevered is $1,320,000. If the firm converts $4 million of equity into debt and Louis holds all the debt, the total cash flow to Louis would be $1,456,000. Therefore, Louis would have a higher total cash flow by $136,000 if the firm leverages by converting $4 million of equity into debt.