# Tax deductible expenses in calculating their taxes

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Unformatted text preview: 2) Tax (40%) After-tax amount [(1) Dividend income 0 \$100,000 (0.70 \$100,000) 70,000 \$100,000 (2)] \$ 30,000 40,000 \$ 60,000 12,000 \$ 88,000 As a result of the 70% dividend exclusion, the after-tax amount is greater for the dividend income than for the interest income. Clearly, the dividend exclusion enhances the attractiveness of stock investments relative to bond investments made by one corporation in another. Tax-Deductible Expenses In calculating their taxes, corporations are allowed to deduct operating expenses, as well as interest expense. The tax deductibility of these expenses reduces their after-tax cost. The following example illustrates the benefit of tax deductibility. 8. The exclusion is 80% if the corporation owns between 20 and 80% of the stock in the corporation paying it dividends; 100% of the dividends received are excluded if it owns more than 80% of the corporation paying it dividends. For convenience, we are assuming here that the ownership interest in the dividend-paying corporation is less than 20%. CHAPTER 1 EXAMPLE The Role and Environment of Managerial Finance 31 Two companies, Debt Co. and No Debt Co., both expect in the coming year to have earnings before interest and taxes of \$200,000. Debt Co. during the year will have to pay \$30,000 in interest. No Debt Co. has no debt and therefore will have no interest expense. Calculation of the earnings after taxes for these two firms is as follows: Debt Co. Earnings before interest and taxes No Debt Co. \$200,000 \$200,000 Less: Interest expense 30,000 0 Earnings before taxes \$170,000 \$200,000 Less: Taxes (40%) Earnings after taxes 68,000 \$102,000 80,000 \$120,000 Difference in earnings after taxes \$18,000 Whereas Debt Co. had \$30,000 more interest expense than No Debt Co., Debt Co.’s earnings after taxes are only \$18,000 less than those of No Debt Co. (\$102,000 for Debt Co. versus \$120,000 for No Debt Co.). This difference is attributable to the fact that Debt Co.’s \$30,000 interest expense deduction prov...
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## This document was uploaded on 01/19/2014.

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