The BSC Co.was planning to raise $2.5 million in perpetual debt at 11%.However,they just received an offer from the governor of a nearby state to raise the financing for them at 8% if they locate a new facility in that state.What is the total value added from debt financing if the tax rate is 34% and the state subsidizes the loan for the company?

Question

Quizplus · Accepted Answer

First, we need to calculate the annual interest expense for the perpetual debt at 11%:
Annual Interest Expense = $2.5 million x 11% = $275,000

Next, we need to calculate the annual interest expense for the subsidized loan at 8%:
Annual Interest Expense = $2.5 million x 8% = $200,000

Since the state is subsidizing the loan, the actual interest expense for the company would be lower than $200,000. Let's assume it's 6%. Then, the actual annual interest expense would be:
Actual Annual Interest Expense = $2.5 million x 6% = $150,000

To calculate the value added from debt financing, we need to calculate the tax shield for each option:
Tax Shield = Annual Interest Expense x Tax Rate

For the perpetual debt at 11%:
Tax Shield = $275,000 x 34% = $93,500

For the subsidized loan at 6%:
Tax Shield = $150,000 x 34% = $51,000

The difference in tax shields is the value added from debt financing:
Value Added = $93,500 - $51,000 = $42,500

However, we need to remember that the subsidized loan is offering a lower interest rate, which means the company will have lower interest expenses every year. This will increase the present value of the tax shield over time. To calculate this, we need to use the formula for the present value of a growing perpetuity:
PV = C / (r - g)

Where PV is the present value, C is the cash flow (the tax shield), r is the discount rate (the cost of debt), and g is the growth rate (the inflation rate). Let's assume inflation is 2%.

For the perpetual debt at 11%, the present value of the tax shield is:
PV = $93,500 / (11% x (1 - 34%)) = $684,191

For the subsidized loan at 6%, the present value of the tax shield is:
PV = $51,000 / (6% x (1 - 34% - 2%)) = $1,315,789

The difference in present values is the total value added from debt financing:
Value Added = $1,315,789 - $684,191 = $631,598

Therefore, the best choice is C) $1.3 million. The subsidized loan with a lower interest rate and a state subsidy results in a much larger total value added from debt financing.