Question

1)An investor considers whether to invest in debt or equity of STU Corporation. Since he already has to pay a high personal tax rate, he does not want to pay more taxes than necessary. Therefore, he weighs the pros and cons of investing in bonds or equities in the local financial markets. The personal tax rate on interest income is 45%, the corporate tax rate is 27.5% and the tax rate on dividends is 20%. Which strategy do you recommend the investor?

2) STU Corporation wants to assess the value of interest savings due to the tax-deductibility of interest on the debt. The corporate tax rate is given above. The total debt stands at $ 7.5mn and the return on debt is 6.5%. Assuming that the current level of debt is permanent, calculate the annual interest payment due and the present value of the perpetual tax shield. Explain in what situations a tax shield might be less relevant and/or even misleading.

Answer 1

1.Suppose the investor receives $ 100 as either interest (if he is a debt-holder)or dividends(if he is a share holder)

he will pay tax at the rate of interest income received, ie. 100*45%=45 & he will net 100-45=$ 55

the $ 100 he received as a shareholder is after the company paid corporate --income tax at the rate of 27.5%--what he receives had already been taxed 27.5% & he has to pay 20% on teh dividend recd. ---the total tax component(as a % of original net income belonging to the share holder) working out to 42% as shown below.

	As interest	As dividend
Amt. received from co.	100	100
Tax $   45%	45	20	20%
Net amt.	55	80
		37.93	already taxed 100/(1-27.5%)*27.5%
		57.93	37.93+20
Tax %	45%	42%	57.93/(100+37.93)

so, investing in equity is recommended.

Net cash in hand is more & total tax % is less (42% as against 45% for interest income)

It also has ownership advantages & voting rights.

2. Annual interest payment for STU Corporation is

$ 7.5 mln.*6.5%=

48.75

mlns.

Interest Tax shield =Annual Interest amt.*Tax %

ie.48.75%*27.5%=

0.1340625

mlns.

Assuming that the current level of debt is permanent

the present value of the perpetual tax shield=

Annual Interset atx shield available/ Gross Cost of debt

ie. 0.134063/6.5%=

2.062508

mlns

Interest tax shileds become irrelevant

for non-tax paying companies

Companies with tax-loss carry-forwards , for a no.of years, might lose the time value of debt -interest tax-shileds.They are only in numbers.