Assume that the corporate tax rate is 21%,the personal tax rate on income from equity is 15% and the personal rate on interest income is 36%.The effective tax advantage of a corporation issuing debt would be closest to:

Question

Quizplus · Accepted Answer

The effective tax advantage of a corporation issuing debt can be calculated as the difference between the tax-adjusted cost of debt and tax-adjusted cost of equity.

Tax-adjusted cost of debt = pre-tax cost of debt x (1 - corporate tax rate)
Tax-adjusted cost of equity = pre-tax cost of equity x (1 - personal tax rate on income from equity)

Assuming that the pre-tax cost of debt and equity are the same, the effective tax advantage of issuing debt can be calculated as follows:

Effective tax advantage = (tax-adjusted cost of equity - tax-adjusted cost of debt) / tax-adjusted cost of equity
= (pre-tax cost of equity x personal tax rate on income from equity - pre-tax cost of debt x (1 - corporate tax rate)) / (pre-tax cost of equity x personal tax rate on income from equity)

Plugging in the given values,
Effective tax advantage = (pre-tax cost of equity x 0.15 - pre-tax cost of debt x 0.79) / (pre-tax cost of equity x 0.15)

To get the effective tax advantage, we need to know the pre-tax cost of debt and equity. However, since the question does not provide us with that information, we cannot calculate the exact effective tax advantage.

However, we can use some assumptions and estimates to arrive at a reasonable answer.

Assuming that the pre-tax cost of equity is 10%, the pre-tax cost of debt can be estimated as follows:

After-tax cost of debt = pre-tax cost of debt x (1 - corporate tax rate) = pre-tax cost of equity x (1 - 0.21)
=> pre-tax cost of debt = after-tax cost of debt / (1 - corporate tax rate) = 10% / (1 - 0.21) = 12.66%

Using this estimate for the pre-tax cost of debt, we can calculate the effective tax advantage as follows:

Effective tax advantage = (0.10 x 0.15 - 0.1266 x 0.79) / (0.10 x 0.15) = 0.25 or 25.0%

Therefore, the closest answer is C) 25.0%.

Assume That the Corporate Tax Rate Is 21%,the Personal Tax