Question

You are investing in an asset that generates $1,000 (pre-tax) in perpetuity and the corporate tax rate is 35%.You are looking at two capital structures:

1)100% equity

2)50% debt (interest expense = $250) and 50% equity

All net income is distributed as a dividend to equity. What is the total cash returned to investors each year?

Answer 1

The question clearly states that,

Profit before Interest and taxes = PBIT = $1000

Interest expenses = $250

Tax rate = 35% = 0.35

Case 1.) 100% equity

Profit Before Taxes (PBT) = PBIT = $1000 (as there is no interest expenses due to Zero debt)

Less : Tax expenses @35% = 0.35 x 1000 = $350

Profit after taxes (PAT) = PBT - Tax Expenses = 1000 - 350 = $650

Total cash available to be returned to investors = $650

Case 2.) 50% equity & 50% Debt

PBIT = $1000

Less: interest expenses = $250

Profit Before Taxes (PBT) = 1000 - 250 = $750

Less : Tax expenses @35% = 0.35 x 750 = $262.50

Profit after taxes (PAT) = PBT - Tax Expenses = 750- 262.50= $487.50

Total cash available to be returned to investors = $487.50