Arnell Industries has just issued $40 million in debt (at par). The firm will pa
ID: 2751280 • Letter: A
Question
Arnell Industries has just issued $40 million in debt (at par). The firm will pay interest only on this debt. Amell's marginal tax rate is expected to be 40% for the foreseeable future.
a. Suppose Arnell pays interest of 9% per year on its debt. What is its annual interest tax shield?
b. What is the present value of the interest tax shield, assuming its risk is the same as the loan?
c. Suppose instead that the interest rate on the debt is 5%. What is the present value of the interest tax shield in this case?
a. Suppose Amell pays interest of 9% per year on its debt. What is its annual interest tax shield?
If Amell pays interest of 9% per year on its debt, the annual interest tax shield is $__ million. (Round to three decimal places.)
b. What is the present value of the interest tax shield, assuming its risk is the same as the loan? The present value of the interest tax shield is $_ _million. (Round to one decimal place.)
c. Suppose instead that the interest rate on the debt is 5%. What is the present value of the interest tax shield in this case?
If instead the fair interest rate on the debt is 5%, the present value of the interest tax shield is
$_ _million. (Round to one decimal place.)
Explanation / Answer
1. Debt=40 million
Interest =9%
tax rate=40%
The value of a tax shield is calculated as the amount of the taxable expense, multiplied by the tax rate.
Taxable expense= 40 million * .09 (9%)
=3.6 million
tax shield = taxable expense * tax rate
=3.6 million * .4 (40%)
=1.44 million
b. present value of the interest tax shield= tax sheild/(1+interest charge)
=1.44 million/(1+.09)
=1.32 million
c. If interest rate on the debt is 5%
Taxable expense= 40 million * .05 (5%)
=2 million
tax shield = taxable expense * tax rate
=2 million * .4 (40%)
=0.8 million
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