Question

You are the CFO of a young firm. You’ve decided to raise $20 million via an eight-year coupon bond with a coupon rate of 10 percent and retire $20 million in common stock. You don’t expect your firm to have positive earnings in years 0 through 3 and you don’t expect to be able to carry any unused tax shield forward. However, in years 4 through 8, you fully expect to benefit from the interest tax shield. What is the present value of the tax shield generated by issuing this bond assuming a tax rate of 40%? What is the present value of the tax shield generated by issuing this bond assuming a tax rate of 0%?

Answer 1

Annual coupon payments of the bond = $20 million * 10%

= $2,000,000

Now tax shield from issuing a bond = coupon payments* tax rate

(i): When tax rate is 40%: The annual tax shield = $2,000,000*40% = $800,000

This will be available for years 4 to 8 i.e. 5 years and so the present value of tax shield = $800,000 per year * 5 years

= $4,000,000

(ii): Here tax rate = 0% and so annual tax shield = $2,000,000*0% = 0

Thus present value of tax shield = $0 per year* 5 years

$0