Question

Suppose the corporate tax rate is 38 %​, and investors pay a tax rate of 30 % on income from dividends or capital gains and a tax rate of 36.9 % on interest income. Your firm decides to add debt so it will pay an additional $ 20 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 tau​*?

Answer 1

a. Debt holders will have to pay the tax on interest income @ 36.9%

Hence Income of debt holders after paying taxes on interest they earn

= Interest Income ( 1 - tax rate on interest income)

= $20 million (1 - 0.369)

= $12.62 million.

b. If firm does not pay $20 million as interest than firm will pay this as dividend. But before giving it as dividend firm has to pay corporate tax on it.

Hence for paying $20 million as interest firm as to cut it dividend each year by

= $20 million(1 - Corporate tax rate)

= $20 million(1 - 0.38)

= $12.4 million

c. As given in the question Equity holder is required to pay tax @30% on income from dividend.

Cut in dividend by the company = $12.4 million (as calculated in part b)

Hence reduction of equityholder's annual after tax income=

Cut in divident(1 - tax on dividend income)

=$12.4 million(1 - .30)

= $8.68 million.

d.

Loss of tax revenue each year by government = Loss of Corporate tax on $20 million + Loss of tax on dividend income of $12.4 million

= ($20 million* .38) + ($12.4 million*.30)

= $11.32 million ........................1

Gain of tax revenue each year by government = tax on interest income

= $20 million*.369

=$7.38 million .........................2

Net loss of revenue to the government = 1 - 2

=$11.32 million - $7.38 million

=$3.94 million

As per the policies, we are only allowed to answer first 4 subparts. Please ask part d as separate one.