Betagamma Inc. booked $120,000 in net income and interest expenses of $20,000 over the past year,...

Betagamma Inc. booked $120,000 in net income and interest expenses of $20,000 over the past year, facing a tax rate of 14%. If Betagamma was instead financed entirely with equity, what would its net income be?

Please, provide an explanation.

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Expert Solution

If Betagamma was instead financed entirely with equity, then there would not be any debt and consequently, there will not be any interest expense.
Net income is the same as profit after tax (PAT)
PAT = Profit before tax (i.e. PBT) × (1 - tax rate)
- ∴ PBT = PAT ÷ (1 - tax rate) = $120,000 ÷ (1 - 0.14) = $120,000 ÷ 0.86 = $139,534.88
Since, there is no interest expense, it is added back. Therefore, revised PBT = $139,534.88 + $20,000 = $159,534.88
Net income if fully financed by equity = $159,534.88 × (1 - 0.14) = $159,534.88 × 0.86 = $137,200
Summarized as a table:
The tax expense increase by $2,800 ($22,334.88 - $19,534.88). This is due to the tax shield on interest available in the financing by both equity and debt. Tax shield on interest expense is not available in full equity financing.
- Tax shield on interest = Interest expense × tax rate = $20,000 × 14% = $2,800

jeff jeffy answered 2 years ago

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