Question

Facebook, Inc. had no debt on its balance sheet in​ 2014, but paid ​$2 billion in taxes. Suppose Facebook were to issue sufficient debt to reduce its taxes by ​$270 million per year permanently. Assume​ Facebook's marginal corporate tax rate is 37 % and its borrowing cost is 4.5 %.

a. If​ Facebook's investors do not pay personal taxes​ (because they hold their Facebook stock in​ tax-free retirement​ accounts), how much value would be created​ (what is the value of the tax​ shield)?

b. How does your answer change if instead you assume that​ Facebook's investors pay a 20 % tax rate on income from equity and a 39.6 % tax rate on interest​ income?

Answer 1

A. Value of Tax Shields = Tax Reduction / Borrowing Cost = $270 Million / 4.5% = $6000 Million or $6 Billion

B. Debt value to provide $250 Million tax shield = Tax Reduction / (corporate tax * Borrowing Cost) = $270 / (37%*4.50%) = $17142.86 Million

Effective Tax Rate = 1 - [(1 - Corporate tax) * (1 - Personal Income Tax)]/(1 - Tax on Interest)]

Effective Tax Rate = 1 - [(1 - 0.37) * (1 - 0.20)]/(1 - 0.396)]

Effective Tax Rate = 1 - 0.8344 = 16.56%

Value of tax Shield = Debt * Tax rate = 17142.86 M * 16.56% = $2838.22 Million