Problem Set #10
GSI: Florent Rouxelin
1520.
Suppose the corporate tax rate is 40%, and investors pay a tax rate of 15% on income from
dividends or capital gains and a tax rate of 33.3% on interest income. Your firm decides to add debt
so it will pay an additional $15 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 de
bt τ*?
1521.
Apple Corporation had no debt on its balance sheet in 2008, but paid $2 billion in taxes. Suppose
Apple were to issue sufficient debt to reduce its taxes by $1 billion per year permanently. Assume
Apple’s marginal corporate tax rate is
35% and its borrowing cost is 7.5%.
a.
If Apple’s investors do not pay personal taxes (because they hold their Apple stock in tax
free
retirement accounts), how much value would be created (what is the value of the tax shield)?
b.
How does your answer cha
nge if instead you assume that Apple’s investors pay a 15% tax rate
on income from equity and a 35% tax rate on interest income?
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 Spring '07
 Berk
 Finance, Basic financial concepts

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