The BSC Co. was planning to raise $2.5 million in perpetual debt at 11 percent. However, they just received an offer from the governor of a nearby state to raise the financing for them at 8 percent if they locate a new facility in that state. What is the total value added from debt financing if the tax rate is 34 percent and the state subsidizes the loan for the company?

Question

Quizplus · Accepted Answer

- At 11% interest rate, the annual interest cost on $2.5 million perpetual debt will be ($2.5 million x 11%) = $275,000
- The interest expense is tax-deductible, which means the company can save taxes equal to (0.34 x $275,000) = $93,500
- Hence, the after-tax cost of debt will be (11% x (1 - 0.34)) = 7.26%
- The present value of perpetual debt with an annual payment of $181,500 ($2.5 million x 0.0726) is ($181,500 / 0.0726) = $2.5 million
- If the company accepts the governor's offer of 8% interest rate, the annual interest cost will be ($2.5 million x 8%) = $200,000
- With the state subsidy, the net interest cost will be (8% - 3%) = 5%
- The after-tax cost of debt will be (5% x (1 - 0.34)) = 3.3%
- The present value of perpetual debt with an annual payment of $82,500 ($2.5 million x 0.033) is ($82,500 / 0.033) = $2.5 million
- Therefore, the value added from debt financing is (($2.5 million at 11%) - ($2.5 million at 8% with subsidy)) = $1.3 million.