In September of 1995, McDonalds Corporation issued $150 million of Senior Notes

Question

In September of 1995, McDonalds Corporation issued $150 million of Senior Notes due in 2005. The notes were issued at par and bore interest of 6 5/8%. The debt was rated AA by Moodys. Interest payments on this debt were deductible for corporate tax purposes (you may assume that McDonalds’s marginal corporate tax rate was 35%), though principal repayments were not. All principal would be repaid in September 2005.

From McDonalds’s perspective, what is the effective after-tax cost of this debt (expressed as an annual percentage)?

How many dollars of taxes will McDonalds save each year through the deduction of the interest expense on these notes from taxable income (you may assume that McDonalds will have sufficient taxable income in future years to cover the interest expense on this debt)? What is the present value of these future tax savings?

Explanation / Answer

Effective after-tax cost of debt = Coupon rate * (1 - tax rate)

= 6.625% * (1 - 35%)

= 4.306%

Dollar tax savings each year = Coupon rate * Debt * tax rate

= $150,000,000 * 6.625% * 35%

= $3,478,125

Considering discounting factor of 10%,

Present value of the future tax savings = Dollar tax savings each year * [1 - 1/(1+discounting rate)No. of years] / discounting rate

= $3,478,125 * [1 - 1/(1+10%)10] / 10%

= $21,371,572

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