Question

Ceteris paribus, if a firm’s tax rate is 35%, an decrease of $1200 in interest expense would result in a change in net income of $_____ and in a change in cash of $ _____.

Answer 1

Solution :

Calculation of change in net income due to decrease in Interest expense :

As per the information given in the question we have

Tax rate = 35%

Decrease in Interest Expense = $ 1,200

If the Interest Expense decreases by $ 1,200 the Income before Tax will Increase by $ 1,200

Thus the Increase in Net Income after tax = Increase in Income before Tax * ( 1 – Tax Rate )

= $ 1,200 * ( 1 – 0.35 )

= $ 1,200 * 0.65

= $ 780

Thus the change in net income due to decrease in Interest expense is

= Increase in Net Income after tax = $ 780

Calculation of change in cash due to decrease in Interest expense :

As per the information given in the question we have

Tax rate = 35%

Decrease in Interest Expense = $ 1,200

If the Interest Expense decreases by $ 1,200, it will result in an Increase in cash flow by $ 1,200.

At the same time since the Income before Tax will Increase by $ 1,200 due to decrease in Interest Expense, it will entail an increased payment of tax on the savings of Interest expense

= Decrease in Interest expense * Tax rate

= $ 1,200 * 35 % = $ 420

Thus change in cash due to decrease in Interest expense = Increase in cash flow by $ 1,200 - Payment of Tax on increase net income due to decrease in Interest expense

= $ 1,200 - $ 420 = $ 780

Thus, Ceteris paribus, if a firm’s tax rate is 35%, an decrease of $1200 in interest expense would result in a change in net income of $ 780 (Increase) and in a change in cash of $ 780 (Increase)

This implies that Net Income would increase by $ 780 and the cash balance would increase by $ 780.