Question

When interest expense is tax-deductible, firms could benefit from the tax shield of debt. Compare two firms with identical assets and operations. One has debt and pays $30 in interest. The other has no debt. If both firms have a revenue of $80 and costs of operations of $20 (excluding interest expense), can you calculate and compare the after-tax payoffs to the two firms? Assume the corporate income tax rate is 20%.

Answer 1

If two firms have similar revenues-

Form A profit would be= (80-20)=60×(1-.2)=$48

Firm B profit=( (80-20)-30)(1-.2)+(30×.2)

= 24+6= $30

Since Firm B profit is lesser because it has an interest expense which is attached to it but there would be lesser number of equity shareholders in Firm B because there is a huge presence of debt shareholding.

since shareholdings patterns of both the firms are different and profits cannot present the true picture because the number of equity shareholders will be lesser in firm B.