The Telescoping Tube Company is planning to raise €2,500,000 in perpetual debt at 11% to ﬁnance part of their expansion.They have just received an offer from the Albanic County Board of
Commissioners to raise the ﬁnancing for them at 8% if they build in Albanic County.What is the total
Added value of debt ﬁnancing to Telescoping Tube if their tax rate is 34% and Albanic raises it for
Them?

Question

Quizplus · Accepted Answer

We can calculate the added value of debt financing by finding the difference in after-tax cost of debt between the two options:

- Telescoping Tube's current option: perpetual debt at 11% 
- Albanic County Board's offer: perpetual debt at 8%

First, let's calculate the after-tax cost of Telescoping Tube's current option:

- Interest expense = €2,500,000 * 11% = €275,000 
- Tax savings = €275,000 * 34% = €93,500 
- After-tax cost of debt = (€275,000 - €93,500) / €2,500,000 = 6.86%

Now, let's calculate the after-tax cost of the Albanic County Board's offer:

- Interest expense = €2,500,000 * 8% = €200,000 
- Tax savings = €200,000 * 34% = €68,000 
- After-tax cost of debt = (€200,000 - €68,000) / €2,500,000 = 5.28%

The difference in after-tax cost of debt is 6.86% - 5.28% = 1.58%.

The added value of debt financing is the present value of the annual interest savings, which is:

- Annual interest savings = €2,500,000 * 1.58% = €39,500 
- Present value at 8% discount rate = €39,500 / 8% = €493,750

Therefore, the total added value of debt financing is €493,750 * 2 = €987,500 (since the debt is perpetual, we need to double the present value to represent the total added value over an infinite period of time).

Adding this added value to the savings on interest expense, the total added value is:

- €987,500 + €75,500 (€275,000 - €200,000) = €1,063,000

Since the question only gives answer choices in increments of €50,000, the closest answer is C) €1,300,000.

The Telescoping Tube Company Is Planning to Raise €2,500,000 in Perpetual