A firm wants to finance an investment that would produce an annual EBIT of $415,000 by...

A firm wants to finance an investment that would produce an annual EBIT of $415,000 by issuing 850 ten-year zero-coupon bonds (each with $1,000 face value) that will be charged a market interest rate of 8%. Suppose the bonds will be issued on January 1, 2020 and will mature on December 31, 2029.

Assume EBIT is constant over time at $415,000 and the tax rate is 35%. Shown below are income statement templates for the years 2020 and 2029. You do not have to fill these in for credit on the exam, however, feel free to use them as guides for determining how the choice of financing will affect the firm's tax liability for these years. Specifically, determine

a) How much the firm saves in taxes in 2020 and how much the firm saves in taxes in 2029 by having this 10-year bond on its books (relative to the case without any borrowing)? (Don't worry about discounting these tax savings back to the present, just consider the nominal dollar amounts.)

b) How much the firm saves in taxes in 2020 and 2029 in present value terms by having this 10-year bond on its books (again, relative to the case without any borrowing). Assume that January 1, 2020 is the "present," the discount rate is 8%, and the taxes would be paid on December 31 of the statement year.

Income statement for 2020 (Jan 1 - Dec 31, 2020)

	With the bond	Without the bond
EBIT	$415,000.00	$415,000.00
Interest
Pre-tax Income
Taxes at 35%
Net Income

Income statement for 2029 (Jan 1 - Dec 31, 2029)

	With the bond	Without the bond
EBIT	$415,000.00	$415,000.00
Interest
Pre-tax Income
Taxes at 35%
Net Income

Solutions

Expert Solution

a) The company will save $11,620 in 2020, the tax saving will be the same for 2029 as well ignoring present values.

	With the bond	Without the bond
EBIT	$415,000.00	$415,000.00
Interest	$33,200.00	$0.00
Pre-tax Income	$381,800.35	$415,000.00
Taxes at 35%	$133,630.12	$145,250.00
Net Income	$248,170.23	$269,750.00
Tax saving	$11,619.88

b) Calculation for 2020

	With the bond	PV	Without the bond	PV
EBIT	$415,000.00	$384,259.26	$415,000.00	$384,259.26
Interest	$33,200.00	$30,740.74	$0.00	$0.00
Pre-tax Income	$381,800.35	$353,518.87	$415,000.00	$384,259.26
Taxes at 35%	$133,630.12	$123,731.60	$145,250.00	$134,490.74
Net Income	$248,170.23	$229,787.26	$269,750.00	$249,768.52
Tax saving	$10,759.14

Calculation for 2029

	With the bond	PV	Without the bond	PV
EBIT	$415,000.00	$207,603.32	$415,000.00	$207,603.32
Interest	$33,200.00	$16,608.27	$0.00	$0.00
Pre-tax Income	$381,800.35	$190,995.41	$415,000.00	$207,603.32
Taxes at 35%	$133,630.12	$66,848.39	$145,250.00	$72,661.16
Net Income	$248,170.23	$124,147.01	$269,750.00	$134,942.16
Tax saving	$5,812.77

jeff jeffy answered 1 month ago

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