Question

1. Given the following:  Corporate tax rate 40%; Dividend/Capital Gains tax rate:  15%; Ordinary income tax rate 35%.  Our company decides to issue incremental debt in order to increase our interest expense by $25 million annually.
   1. How much will debt holders receive after all applicable taxes are paid?
   2. How much will the company need to reduce its dividend in order to pay the additional interest expense?
   3. How much will the dividend cut reduce shareholder after-tax annual income?
   4. How much more or less will the government receive in tax revenues from our company and its bondholders and shareholders?
   5. What is the effective tax advantage of debt, t^*?

Answer 1

Solution:

a)Net Amount received by bond holders

Since interest on debt is tax deductible for the company,hence company is not required to pay tax on interest.However Interest received by the bondholders is the ordinary income for them,thus net amount received by them is net of tax paid as follows;

Net Amount received=Interest Income(1-Ordinary Tax rate)

=$25000,000(1-0.35)=$16250,000

b)Reduction in Dividend

Company is required to reduce the dividend upto the amount of interest after all tax as follows;

=Interest Income-Corporate tax

=$25000,000(1-0.40)

=$15000,000

c)Reduction in after tax annual income of Shareholders

Since dividend received by shareholders are subject to dividend tax @15%,thus reduction in after tax annual income is calculated as follows;

=Dividend cut(1-dividend tax rate)

=$15000,000(1-0.15)

=$12750,000

d)Governement will receive following amount

Receive more from Bondholders=Interest Income*35%

=$$25000,000*35%=$8,750,000

Receive less from company=$25000,000*40%=$10,000,000

Receive less from shareholders=$15000,000*15%=$2250,000