Use the following information to answer the question(s)below.
Google Corporation has no debt on its balance sheet in 2008,but paid $1.6 billion in taxes.Assume that Google's marginal tax rate is 35% and Google's borrowing cost is 7%.
-Assume that investors in Google pay a 15% tax rate on income from equity and a 25% tax rate on interest income.If Google were to issue sufficient debt to reduce its taxes by $600 million per year permanently,then the effective tax advantage of this debt would be closest to:

Question

Quizplus · Accepted Answer

Google's current tax payment of $1.6 billion implies that the company had pre-tax income of $4.57 billion (given a 35% marginal tax rate). To permanently reduce taxes by $600 million, Google needs to deduct $1.714 billion in interest payments each year (given a 7% borrowing cost).

To determine the tax advantage of this debt, we compare the tax payments Google would make with and without the interest deductions.

Without debt:
Pre-tax income: $4.57 billion
Tax payment (35%): $1.60 billion
After-tax income to equity investors (15% tax rate): $2.92 billion

With debt:
Pre-tax income: $2.86 billion ($4.57 billion - $1.71 billion in interest payments)
Tax payment (35%): $1.00 billion
After-tax income to equity investors (15% tax rate): $1.849 billion [=$2.86 billion*(1-0.15)]
After-tax income to debt investors (25% tax rate): $1.286 billion [=$1.714 billion*(1-0.25)]

The tax advantage of the debt is the reduction in tax payments for equity investors, in this case $1.070 billion ($2.92 billion - $1.849 billion), divided by the total interest payments of $1.714 billion. This yields an effective tax advantage of approximately 62% (($1.07 billion/$1.714 billion)*100%).

However, the question asks for the effective tax advantage for all investors. Taking into account the tax payments from both equity and debt investors, the effective tax advantage of the debt is approximately 25% [($1.07 billion + $0.429 billion)/($1.714 billion)*100%]. Therefore, the closest answer is C) 25%.

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