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The tax deductibility of certain expenses reduces

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Unformatted text preview: ided a tax savings of $12,000 ($68,000 for Debt Co. versus $80,000 for No Debt Co.). This amount can be calculated directly by multiplying the tax rate by the amount of interest expense (0.40 $30,000 $12,000). Similarly, the $18,000 after-tax cost of the interest expense can be calculated directly by multiplying one minus the tax rate by the amount of interest expense [(1 0.40) $30,000 $18,000]. The tax deductibility of certain expenses reduces their actual (after-tax) cost to the profitable firm. Note that both for accounting and tax purposes interest is a tax-deductible expense, whereas dividends are not. Because dividends are not tax deductible, their after-tax cost is equal to the amount of the dividend. Thus a $30,000 cash dividend has an after-tax cost of $30,000. Capital Gains capital gain The amount by which the sale price of an asset exceeds the asset’s initial purchase price. If a firm sells a capital asset (such as stock held as an investment) for more than its initial purchase price, the difference between the sale price and the purchase price is called a capital gain. For corporations, capital gains are added to ordinary corporate income and taxed at the regular corporate rates, with a maximum marginal tax rate of 39 percent.9 To simplify the computations presented in the text, as for ordinary income, a fixed 40 percent tax rate is assumed to be applicable to corporate capital gains. 9. The Omnibus Budget Reconciliation Act of 1993 included a provision that allows the capital gains tax to be halved on gains resulting from investments made after January 1, 1993, in startup firms with a value of less than $50 million that have been held for at least 5 years. This special provision, which is intended to help startup firms, is ignored throughout this text. 32 PART 1 Introduction to Managerial Finance EXAMPLE Ross Company, a manufacturer of pharmaceuticals, has pretax operating earnings of $500,000 and has just sold for $40,000 an asset that was purchased 2 years ago for $36,000. Bec...
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