Finance for Managers Essay

795 WordsMar 25, 20154 Pages
1. What is meant by saying debt is tax-favored? What is the benefit to the firm? What are the risks? (DO THE MATH) When filing your taxes at the end of the year, you look to maximize your deductions and credits wherever possible. The same is true for businesses. The more deductions and credits you are able to utilize, the lower your tax liability. Credits typically differ from year to year, but deductions tend to remain the same. For companies, this is important. Interest is a tax deductible charge. It can be written off at the end of the year. If Company A takes out a loan in the amount of $2,400,000 at a 7% interest rate, Company A is on the hook for $192,000 in interest charges in addition to the original loan amount of $2,400,000 (total of $2,592,000). Because the company is able to write off a portion of the interest as a tax deduction, this reduces the company’s actual cost of the loan. Amount Financed: $2,000,000 Interest Rate: 7% Interest Charged: $192,000 Total: $2,192,000 By taking the interest charged and multiplying it by 35% (federal tax reduction rate), added with the interest charged and multiplied by 5%, you will have your total tax reduction. $192,000 x 35% = $67,200 $192,000 x 5% = $9,600 Total tax reduction= $76,800 The true value of what the company paid for the loan plus interest is $2,515,200. This is calculated by taking the original loan amount ($2,400,000), 7% interest ($192,000), and subtracting the tax reduction ($76,800) equals $2,515,200. If Company B uses $2,400,000 in stock to fund its operations, there is no interest to write off. Therefore, the company’s true expense is the full $192,000 to shareholders because they are not eligible for any reductions. There are risks associated with utilizing debt as opposed to stock. You do not pay dividends on the stock if you do not make a profit. However, when

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