Tax and Gearing

W22Extra: Tax and Gearing: More Questions Multiple Choice

1) Which of the following statements is false?

• A) In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield.

• B) The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage.

• C) Because Corporations pay taxes on their profits after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay.

• D) As Modigliani and Miller made clear in their original work, capital structure matters in perfect capital markets.

Thus, if capital structure does not matter, then it must stem from a market imperfection. As Modigliani and Miller made clear in their original work, capital structure does not matter in perfect capital markets. Thus, if capital structure matters, then it must stem from a market imperfection. Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 35%.

2) Rosewood’s net income is closest to:

• A) $450 million

• B) $180 million

• C) $290 million

• D) $95 million

Net income = (EBIT – Interest expense)(1 – C) = (450 – 175)(1 – . 35) = $178. 75 3)

The total of Rosewood’s net income and interest payments is closest to:

• A) $270 million

• B) $355 million

• C) $290 million

• D) $450 million

Net income + Interest = (EBIT – Interest expense)(1 – C) = (450 – 175)(1 – . 35) = $178. 75 + $175 = $353. 73

4) If Rosewood had no interest expense, its net income would be closest to:

• A) $405 million

• B) $160 million

• C) $450 million

• D) $290 million

Net income = (EBIT – Interest expense)(1 – C) = (450 – 0)(1 – . 35) = $292. 50 5) The amount of Rosewood’s interest tax shield is closest to:

• A) $115 million

• B) $290 million

• C) $175 million

• D) $60 million

Interest tax shield = Interest expense(C) = 175(. 35) = $61. 25

Fly by Night Aviation (FBNA) expects to have net profit available for shareholders next year of 24 million and Free Cash Flow of 27 million. FBNA’s marginal corporate tax rate is 40%.

6) Establish FBNA’s EBIT

• A) 43 million

• B) 40 Million

• C) 45 million

• D) 60 million

EBIT = NI + Taxes + Interest expense FCF = NI + Interest expense => 27 = 24 + interest expense = 3 (EBIT – Interest Expense)(1 – 0. ) = NI (EBIT – 3)(0. 6) = 24 (EBIT – 3) = 24/0. 6 = 40 EBIT = 40 + 3 = $43

7) IF FBNA increases leverage so that its interest expense rises by 1 million, then the amount its profit for shareholders will change is closest to:

• A) 400,000

• B) 600,000

• C) 400,000

• D) 600,000

(EBIT – Interest Expense – chg IE)(1 – 0. 4) = NI + chg NI (- chg IE)(0. 6) = chg NI -1m (. 6) = -600,000 Or, -$1m (1 – . 4) = -$600,000

8) IF FBNA increases leverage so that its interest expense rises by 1 million, then the amount its Free Cash flow will change is closest to:

• A) 600,000

• B) 400,000

• C) 600,000

• D) 400,000

FCF = NI + Interest expense chg FCF = chg NI + chg Interest expense = – 600,000 + 1m = +400,000 Or, $1m (0. 4) = $400,000

LCMS Industries has 70 million in debt outstanding. The firm will pay only interest on this debt (the debt is perpetual). LCMS’ marginal tax rate is 35% and the firm pays a rate of 8% interest on its debt.

9) LCMS’ annual interest tax shield is closest to:

• A) 2. 8 million

• B) 2. 0 million

• C) 3. 6 million

• D) 5. 6 million

Annual Tax shield= annual debt interest C = 70M 0. 08 .35 = 1. 96M

10) Assuming that the risk is the same as the loan, the present value of LCMS’ interest tax shield is closest to:

• A) 45. 5 million

• B) 20. 0 million

• C) 24. 5 million

• D) 35. 0 million

PV of Tax shield = debt C = 70M .35 = 24. 5M

11) Assuming that the risk of the tax shield is only 6% even though the loan pays 8%, then the present value of LCMS’ interest tax shield is closest to:

• A) 24. 5 million

• B) 18 million

• C) 33. 0 million

• D) $20. 0 million

PV of Tax shield = debt C rD / rD2 = $70M .35 .08/. 06 = 32. 67