Empire Industries forecasts net income this coming year as shown below (in thous
ID: 2798307 • Letter: E
Question
Empire Industries forecasts net income this coming year as shown below (in thousands of dollars):
EBIT
$1 comma 000
Interest expense
0
Income before tax
$1 comma 000
Taxes
negative 400
Net income
$nbsp 600
Approximately
$ 150 comma 000
of Empire's earnings will be needed to make new,
positive-NPV
investments. Unfortunately, Empire's managers are expected to waste
10 %
of its net income on needless perks, pet projects, and other expenditures that do not contribute to the firm. All remaining income will be distributed to shareholders.
a. What are the two benefits of debt financing for Empire?
b. By how much would each
$ 1
of interest expense reduce Empire's distributions to shareholders?
c. What is the increase in the total funds Empire will pay to investors for each
$ 1
of interest expense?
a. What are the two benefits of debt financing for Empire? (Select the best choice below.)
A.
Tax and interest cost benefits
B.
Dividend and tax benefits
EBIT
$1 comma 000
Explanation / Answer
Empire Industries a. What are the two benefits of debt financing for Empire? In addition to tax benefits of leverage , debt financing can benefit Empire by reducing wasteful investment. b. By how much would each $ 1 of interest expense reduce Empire's distributions to shareholders? Net Income will fall by $ 1 x 0.60 = $ 0.60 Because 10% of net income will be wasted , divdends and share repurchases will fall by $ 0.60 x ( 1 - 0.10 ) = $ 0.54 c. What is the increase in the total funds Empire will pay to investors for each $ 1 of interest expense? Pay $ 1 in interest , give up $ 0.54 in dividends and share repurchases - > increase of 1 - 0.54 = $ 0.46 per $ 1 of interest.
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