Question

You have the following information about the James E. Briley company. Sales $225,000 Operating Expenses $50,000 Depreciation $25,000 If the company borrows money, it will borrow $50,000 at an interest rate of 11 percent, which is considered to be the risk free rate of interest. Thus, the total annual interest payments will be $5,500. When appropriate the corporate tax rate (Tc) is 34 percent, the personal taxi rate on income from bonds (Tpb) is 40 percent and the personal tax rate on income from stocks (Tps) is 28 percent. The cost of equity for the company is 14 percent. What is the gain from using debt in the capital structure if the firm is subject to pass-through taxation?

• A. $6,000
• B. -$6,000
• C. $6,240
• D. $0.00
• E. $225,000

Answer 1

Refer below tables

Table 1 - Income statement without debt in capital structure

Table 2 - Income statement with debt in capital structure

Table 1

Description	Value
Revenue	225000
Operating expense	50000
Depreciation expense	25000
Operating profit	150000
Income taxes @ 34%	51000
Net Income	99000

Table 2

Description	Value
Revenue	225000
Operating expense	50000
Depreciation expense	25000
Operating profit	150000
Interest expense	5500
Income before tax	144500
Income tax @ 34%	49130
Net Income	95370

Now formula for free cash flow to firm ( FCFF) = Net income + depreciation + Interest x ( 1-tax) - fixed capital investment - working capital

In example given fixed capital investment and working capital are not given , hence same are assumed to be 0

FCFF for table 1 ( i.e. without debt ) = 99000 + 25000 = 124000

FCFF for table 2 (i.e. with debt) = 95370 +25000 + 5500*(1 - 0.34) = 124000

As we see free cash flow to firm (FCFF) in both cases is same therefor there is no net gain or loss

Hence answer to this question is D