Demonstrating the tax advantage of debt financing

Below is the income statement for a hypothetical firm. We assume the firm faces zero risk and that the income statement will remain unchanged forever. We make these assumptions in order to simplify the arithmetic but the basic points will remain in a more realistic setting. All present values are to be computed using 5% and the level perpetuity assumption. There are 100 shares outstanding.

Revenue $100

Expenses 40

Depreciation 10

E.B.I.T. $50

Interest -0-

Taxable Inc. $50

Tax (40%) 20

Earnings $30

CashDividend $30

The firm uses its $10 depreciation allowance to reinvest and maintain the real assets necessary to produce this steady level of revenues and expenses.

1. Calculate the market value of all shares and the market value of one share both with dividend and without dividend (call it ex-dividend).

Now….issue debt (bonds) worth $600. For now, let’s assume we are going to take the $600 and pay it to shareholders as a cash dividend.

2. Redo the income statement above to reflect this change.

3. Calculate the market value of all shares and the market value of one share both with dividend and without dividend (call it ex-dividend).

4. Calculate the amount of annual tax paid to the government both before the firm decided to use debt financing and then again after the firm decided to use debt financing.

5. From #4, calculate the present value of the tax obligation under both scenarios. Could the difference in present values explain the increase in shareholder wealth.

6. Calculate the NPV of the debt issue directly. NPV is just the $600 that comes in right away minus the present value of the incremental cash flows going out. Is NPV the present value of interest tax savings?

7. Now suppose the firm decides to use the $600 from the bond issue to repurchase shares rather than to pay a cash dividend. How many shares will be repurchased and what will be the share price?

8. Suppose the firm decides to issue $600 of debt for only one year. What is the NPV and what is the present value of interest tax savings.

9. Suppose the firm decides to issue $600 of debt and repay the debt with two equal annual payments. What is the present value of interest tax savings now?