Question

Interest versus dividend expense Michaels Corporation expects earnings before in- terest and taxes to be $50,000 for the current period. Assuming an ordinary tax rate of 35%, compute the firm’s earnings after taxes and earnings available for common stockholders (earnings after taxes and preferred stock dividends, if any) under the following conditions: a. The firm pays $12,000 in interest. b. The firm pays $12,000 in preferred stock dividends.

Answer 1

The Michaels Corporation will have earnings after taxes of $24,700 and earnings available for common stockholders also of $24,700 when paying $12,000 in interest. If paying $12,000 in preferred stock dividends instead, the earnings after taxes would be $32,500, with $20,500 available for common stockholders.

Step-by-step explanation:

The Michaels Corporation expects earnings before interest and taxes (EBIT) of $50,000. With a tax rate of 35%, we will calculate the firm's after-tax earnings and the earnings available to common stockholders under two scenarios: one involving interest payments, and the other involving preferred stock dividends.

Case a: Paying Interest

1. Calculate earnings after interest: EBIT - Interest = $50,000 - $12,000 = $38,000.
2. Compute taxes: $38,000 * 35% = $13,300.
3. Deduct taxes to find earnings after taxes (EAT): $38,000 - $13,300 = $24,700.
4. Since there are no preferred dividends in this scenario, earnings available for common stockholders is also $24,700.

Case b: Paying Dividends

1. Since preferred stock dividends are paid from after-tax earnings, we first calculate EAT: EBIT - Taxes. Taxes = $50,000 * 35% = $17,500.
2. Earnings after taxes: $50,000 - $17,500 = $32,500.
3. Subtract preferred stock dividends: $32,500 - $12,000 = $20,500, which is the earnings available for common stockholders.

In both cases, the difference in earnings after taxes and earnings available for common stockholders reflects the financial decisions made by the firm, whether to service debt through interest payments or reward shareholders through dividends.

Answer 2

a. In case of interest paid = $24,700.

b. In Case Preferred Dividend is Paid = $20,500

Step-by-step explanation:

Earnings before Interest And Taxes (EBIT) = $50,000

a. In case of interest paid

EBIT = $50,000

Less: Interest = $12,000

Earnings Before Taxes = $50,000 - $12,000 = $38,000

Less: Tax @35% = $38,000 X 0.35 = $13,300

Earnings After Tax =$38,000 - $13,300 = $24,700.

This is the value available for common stock.

b. In Case Preferred Dividend is Paid

EBIT = $50,000

Less: Taxes @ 35 % = $50,000 X 0.35 = $17,500

Earnings After Tax = $50,000 - $17,500 = $32,500

Less: Preference Dividend = $12,000

Earnings available for equity or common stock = $32,500 - $12,000 = $20,500

The difference is of tax benefit on payment of interest as that is taxable and preference dividend is not taxable.

a. In case of interest paid = $24,700.

b. In Case Preferred Dividend is Paid = $20,500