A company issued $1,000,000 of 10% notes that resulted in interest expense of $100,000 per year. What is the company's net cash outflow if the effective tax rate is 40%?

Question

Quizplus · Accepted Answer

To calculate the company's net cash outflow due to the interest expense, we need to consider the effect of the tax savings from the interest expense deduction.
The company has issued $1,000,000 of 10% notes, which results in an annual interest expense of $100,000. This interest expense is tax-deductible, meaning it reduces the company's taxable income, and therefore, the company will save on taxes.
The effective tax rate is 40%, so the tax savings on the interest expense would be:
Tax Savings = Interest Expense x Tax Rate
Tax Savings = $100,000 x 40%
Tax Savings = $40,000
The tax savings reduce the actual cash outflow for the interest expense. Therefore, the net cash outflow is the interest expense minus the tax savings:
Net Cash Outflow = Interest Expense - Tax Savings
Net Cash Outflow = $100,000 - $40,000
Net Cash Outflow = $60,000
So, the company's net cash outflow due to the interest expense, after accounting for the tax savings, is $60,000.
The correct answer is b. $60,000.

A Company Issued $1,000,000 of 10% Notes That Resulted in Interest