Suppose the corporate tax rate is 35%, and investors pay a tax rate of 25% on income from dividends or capital gains and a tax rate of 32.4% on interest income. Your firm decides to add debt so it will pay an additional $30 million in interest each year. It will pay this interest expense by cutting its dividend.
a. How much will debt holders receive after paying taxes on the interest they earn?
b. By how much will the firm need to cut its dividend 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 t*?
Suppose the corporate tax rate is 40%. Consider a firm that
earns $1000 before interest and taxes each year with no risk. The
risk-free interest rate is 5%. (Please show steps and
- Suppose the firm has no debt and pays out its net income as
dividend each year. What is the value of the firm’s equity?
- Suppose instead the firm makes interest payments of $500 per
year on a perpetual bond. What is the value of equity? What is the
value of debt?
- What is the difference between the total value of the firm with
leverage and without leverage?
- To what percentage of the value of the debt is the difference
in part 3. equal?