The benefits of debt: A firm plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the firm's annual tax liability?

Question

Quizplus · Accepted Answer

The annual interest expense on the debt issuance would be: $1,000,000 x 9% = $90,000

The tax savings would be:
Marginal tax rate savings: $90,000 x 25% = $22,500
Average tax rate savings: $90,000 x 15% = $13,500

Since the marginal tax rate is higher than the average tax rate, the firm would save more on taxes by using the marginal tax rate. Therefore, the debt issuance would reduce the firm's annual tax liability by $22,500.

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