Question

Grommit Engineering expects to have net income next year of $ 50.31 million and free cash flow of $ 22.15 million. ​ Grommit's marginal corporate tax rate is 30 %.

a. If Grommit increases leverage so that its interest expense rises by $ 16.4 ​million, how will net income​ change?

b. For the same increase in interest​ expense, how will free cash flow​ change?

Answer 1

(a) Net Income = $ 50.31 million, Increase in Interest Expense = $ 16.4 million and Tax Rate = 30 %

An increase in interest expense will reduce the net income by the amount of the after-tax interest expense

Therefore, Change in Net Income = (1-0.3) x 16.4 = $ 11.48 million

New Net Income = 50.31 - 11.48 = $ 38.83 million

(b) An increase in interest expense will lead to an increase in the free cash flow by the amount of the after-tax value of the interest expense.

After-Tax Interest Expense = 16.4 x (1-0.3) = $ 11.48 million

New Free Cash Flow = 22.15 + 11.48 = $ 33.63 million