Question

PMF, Inc., can deduct interest expenses next year up to​ 30% of EBIT. This limit is equally likely to be $ 18 ​million, $ 23 ​million, or $ 28 million. Its corporate tax rate is 30 %​, and investors pay a 25 % tax rate on income from equity and a 35 % tax rate on interest income.

a. What is the effective tax advantage of debt if PMF has interest expenses of ​$14 million this coming​ year?

b. What is the effective tax advantage of debt for interest expenses in excess of $ 28 ​million? (Ignore​ carryforwards).

c. What is the expected effective tax advantage of debt for interest expenses between $ 18 million and $ 23 ​million? (Ignore​ carryforwards).

d. What level of interest expense provides PMF with the greatest tax​ benefit

Answer 1

Effective tax advantage = 1- [ (1- corporate tax) (1- tax on equity) / (1 - interest rate tax)]

a. Tax advantage =1- [ (1- 30%) (1- 25%) / (1 - 35%)]

= 19.2%

b. If interest expenses in excess of $ 28 ​million , then net income is $0, then corporate tax is 0%

Tax advantage =1- [ (1- 0%) (1- 25%) / (1 - 35%)]

= - 15.4%

c. Probability of corporate tax rate = 2/3* 30% = 20% [ 2/3 is probability since out of 3 times, 2 instances the company will have a positive net income]

Tax advantage =1- [ (1- 20%) (1- 25%) / (1 - 35%)]

= 7.7%

d. Option ,if PMF has interest expenses of ​$14 million this coming​ year.