The benefits of debt: Packman Company has a reported EBIT of $500, which is expected to remain constant in perpetuity. If the company borrows $2,000, its YTM will be 6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings?

Question

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By taking on debt, Packman Company is able to lower its cost of capital, as the interest payments on the debt are tax deductible. The after-tax cost of debt is calculated as follows:
After-tax cost of debt = YTM x (1 - marginal tax rate)
After-tax cost of debt = 6.5% x (1 - 30%)
After-tax cost of debt = 4.55%
The interest payments on the debt are then calculated as:
Interest payments = Total debt x coupon rate
Interest payments = $2,000 x 8%
Interest payments = $160
The tax savings from the interest payments are calculated as:
Tax savings = Interest payments x marginal tax rate
Tax savings = $160 x 30%
Tax savings = $48
Therefore, the after-tax earnings are calculated as:
After-tax earnings = EBIT - Interest payments + Tax savings
After-tax earnings = $500 - $160 + $48
After-tax earnings = $388
However, this is the after-tax earnings assuming the company does not have any debt. To calculate the after-tax earnings with the debt, we need to subtract the after-tax cost of debt:
After-tax earnings with debt = After-tax earnings - (Total debt x After-tax cost of debt)
After-tax earnings with debt = $388 - ($2,000 x 4.55%)
After-tax earnings with debt = $238
Therefore, the answer is (A) $238.

The Benefits of Debt: Packman Company Has a Reported EBIT