The Telescoping Tube company is planning to raise $2,500,000 in perpetual debt at 11% to finance part of their expansion. They have just received an offer from the Albanic County Board of Commissioners to raise the financing for them at 8% if they build in Albanic County. What is the total added value of debt financing to Telescoping Tube if their tax rate is 34% and Albanic raises it for them?

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Quizplus · Accepted Answer

The added value of debt financing can be calculated by comparing the after-tax costs of the two financing options. The interest expense is tax-deductible, so the after-tax cost of debt is the interest rate multiplied by (1 - tax rate).For the original 11% financing:After-tax cost = 11% * (1 - 34%) = 7.26%For the 8% financing offered by Albanic County:After-tax cost = 8% * (1 - 34%) = 5.28%The difference in after-tax cost is 7.26% - 5.28% = 1.98%.The added value of the lower-cost debt financing is the perpetual savings from the lower interest rate, which can be calculated as the difference in after-tax cost times the amount of debt:Added value = 1.98% * $2,500,000 = $49,500 per year, perpetually.To find the present value of these perpetual savings, we divide by the after-tax cost of the new debt:$$ \text{Added value} = \frac{\$49,500}{0.0528} = \$937,121.21 $$However, since none of the provided choices exactly match this calculation and the approach seems to have been misunderstood, we should instead calculate the total interest savings without converting them into a present value, considering the question might be asking for the nominal difference in interest costs before considering tax effects:$$ \text{Interest Savings} = (\text{Original Interest Rate} - \text{New Interest Rate}) \times \text{Debt Amount} $$$$ \text{Interest Savings} = (11\% - 8\%) \times \$2,500,000 $$$$ \text{Interest Savings} = 3\% \times \$2,500,000 = \$75,000 \text{ per year} $$To find the total added value, we consider the tax savings due to the lower interest rate:$$ \text{Tax Savings} = \$75,000 \times 34\% = \$25,500 \text{ less paid in taxes per year} $$The total savings then are the interest savings less the tax savings, perpetually. However, the calculation provided does not directly lead to any of the given answer choices, indicating a misunderstanding in the approach. The correct approach should directly compare the total costs of the two options, taking into account the perpetual nature of the debt and the tax savings from the lower interest rate offered by Albanic County. Given the misunderstanding in the calculation process, the correct answer is derived from understanding the perpetual savings from the lower interest rate, which should be calculated based on the interest cost difference and the tax shield benefit, leading to a significant perpetual savings that, when valued as a perpetuity, would align with the correct choice provided. Given the options and the typical approach to such a problem, the correct answer would involve calculating the difference in interest payments, considering the tax shield, and then understanding this as a perpetual saving. However, without the precise calculation leading to one of the provided choices, there's a gap in the explanation provided. The correct approach involves understanding the perpetual nature of the savings and applying the formula for the present value of a perpetuity: PV = Payment / r, where Payment is the annual savings and r is the discount rate, which in this context, could be interpreted as the interest rate. However, the direct calculation leading to the exact answer choice was not correctly outlined based on the initial explanation.

The Telescoping Tube Company Is Planning to Raise $2,500,000 in Perpetual