Question

Arnell industries has just issued $35 million in debt at par (i.e., at its face value). The firm will pay interest only on this debt. Arnell's marginal tax rate is expected to be 28% for the foreseeable future. (Round all numbers to three decimal places.)

(a) Suppose Arnell pays interest of 8% per year on its debt. What is its annual interest tax shield?
(b) What is the present value of the interest tax shield, assuming its risk is the same as the loan?

Answer 1

The annual interest tax shield for Arnell industries is $784,000, and the present value of the interest tax shield is $725,925.

Step-by-step explanation:

The annual interest tax shield is calculated by multiplying the debt amount by the interest rate and the tax rate. In this case, the debt amount is $35 million, the interest rate is 8%, and the tax rate is 28%. So, the annual interest tax shield is:

$35,000,000 * 8% * 28% = $784,000

The present value of the interest tax shield can be calculated by discounting the annual interest tax shield at the relevant discount rate. Since the risk of the loan is the same as the bond, we can use the same discount rate as the bond's yield. Assuming a discount rate of 8%:

The present value of the interest tax shield is:

$784,000 / (1 + 8%) = $725,925