Question

Suppose the corporate tax rate is

35%​,

and investors pay a tax rate of

15%

on income from dividends or capital gains and a tax rate of

37.3%

on interest income. Your firm decides to add debt so it will pay an additional

$20

million in interest each year. It will pay this interest expense by cutting its dividend.

a. How much will debt holders receive after paying taxes on the interest they​ earn?

b. By how much will the firm need to cut its dividend each year to pay this interest​ expense?

c. By how much will this cut in the dividend reduce equity​ holders' annual​ after-tax income?

d. How much less will the government receive in total tax revenues each​ year?

e. What is the effective tax advantage of debt

Answer 1

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