Question

Garrison's had EBIT of $10M in 2019 and expects consistent performance going forward. It is looking to optimize its capital structure by adding $50M of permanent debt. The interest rate is 5% and tax rate is 25%. What is the present value of tax shields for the firm?

n/a…this erodes value as interest expense is too high and causes indirect financial distress cost

$0.625M

$12.5M

$2.5M

Answer 1

Solution :

The formula for calculating the present value of Interest tax shield is

= Interest expense * Tax rate

As per the information given in the question we have

Debt amount = $ 50M ; Interest rate = 5 %   ; Tax rate = 25 % = 0.25 ;

Thus the Interest expense on the debt is = Debt amount * Interest rate

= $ 50M * 5% = $ 2.5M

Interest Expense = $ 2.5M

Applying the above values in the formula for present value of Tax shield we have

= $ 2.5M * 0.25

= $ 0.625M

Thus the present value of Tax shield = $ 0.625M

The solution is option 2 = $ 0.625M