The BSC Co. is planning to raise $2.5 million in perpetual debt at 11%. They have just received an offer from the governor to raise the financing for them at 8%, if they locate themselves in the state. What is the total value added from debt financing if the tax rate is
34% and the state raises the loan for the company?

Question

Quizplus · Accepted Answer

Since the state is offering a lower interest rate of 8%, the company would save 3% in interest expense. This savings in interest would reduce the company's taxable income by $75,000 per year ($2.5 million x 3%). At a tax rate of 34%, the company's tax savings would be $25,500 per year ($75,000 x 0.34). Therefore, the annual net savings for the company from the lower interest rate and tax savings would be $100,500 per year ($75,000 + $25,500). The total value added from debt financing would be the present value of this perpetual annual savings, which would be $1.3 million (($100,500 / 0.08) x (1 - 0.34)). Therefore, the best choice is C as it represents the total value added from debt financing.