Question

Red and Blue have EBIT of $20.0M and pay tax at a flat rate of 30%.  Red is equity financed and pays $1.2M in dividends while Blue is debt financed and pays 1.2M in interest.  How much will each company add to its retained earnings for the year.  Explain the difference.

Answer 1

($ in millions)
	Red	Blue
	Equity Financed	Debt Financed
EBIT	$20.00	$20.00
Interest	($0.00)	($1.20)
EBT	$20.00	$18.80
Tax @ 30%	($6.00)	($5.64)
Net Income	$14.00	$13.16
Dividends	($1.20)	($0.00)
Net Retained Earnings	$12.80	$13.16

Blue is able to retain more because its interest payment to debt investors is tax deductible while Red’s dividend payment to equity investors is not.