Question

. Suppose the corporate tax rate is 35% and investors pay a tax rate of 15% on income from dividends or capital gains and a tax rate of 29% on interest income. Your firm adds debt so it pays an additional $15 million in interest each year. It pays this interest expense by cutting its dividend. a. How much will debt holders receive after paying taxes? b. By how much will the firm need to cut its dividends each year to pay this interest expense? c. By how much will this cut in the dividend reduce equity holders’ annual after-tax income? d. How much less will the government receive in total tax revenues each year? e. What is the effective tax advantage of debt?

Answer 1

a. Interest ( 1- tax) = $15( 1-0.29)

= $10.65 million each year

b. Given, a corporate rate tax is 35% and interest expense of 15 million per year reduces net income by -

$15( 1-.35) = $9.75 million after corporate taxes.

c. $9.75 million dividend cut -

9.75( 1-.15) = $8.28 million per year.

d. Interest taxes - .29× 15 = $4.35 million

Less- corporate taxes .35×15 =$5.25 million

Leas- dividend taxes .15×9.75 = $1.46 million

Govt. Tax revenues change by - 4.35-5.25-1.46= -2.36

e. Tax = (1-.35)(1-.15)/ (1-.29)= 0.7781

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