Question

Suppose the corporate tax rate is 38%​, and investors pay a tax rate of 15% on income from dividends or capital gains and a tax rate of 30.1% 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 tauτ​*?

Answer 1

Solution:

a. Debt holders receive after paying taxes = $20 million x (1 - 0.301)

Debt holders receive after paying taxes = $13.98 million

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b. An interest expense of $20 million per year reduces net income by $20 million x (1 - 0.38) = $12.4 million after corporate taxes. Therefore, dividend will be $12.4 million

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c. $12.4 million cut -----> $12.4 million *(1 - 0.15) = $12.02 million

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d. Interest expense = 0.301 x $20 million = $6.02 million

Corporate taxes = 0.38 x $20 million = $7.6 million

Dividend taxes = 0.15 x $20 million = $3 million

Government tax revenue change by $6.02 million - $7.6 million - $3 million = -$4.58 million

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e. T* = 1 - [(1 - 0.38) (1 - 0.15)]/(1-0.301)

T* = 1 - 0.7539

T* = 0.2461