The benefits of debt: A company plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The company's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the company's annual tax liability?
A) $13,500
B) $22,500
C) $32,500
D) None of the above.

Question

Quizplus · Accepted Answer

The annual interest expense on the debt can be calculated as:
Annual interest expense = $1,000,000 * 9% = $90,000
The tax shield generated by the interest expense can be calculated as:
Tax shield = $90,000 * 25% = $22,500
Since the debt reduces the company's taxable income, we need to calculate the tax savings at the marginal tax rate of 25%. Thus, the debt issuance will reduce the company's annual tax liability by $22,500. Therefore, the correct answer is B.

The Benefits of Debt: a Company Plans to Issue $1