Question

Flying Tiger Corp. is currently unlevered, has equity valued at $668750, and has earnings before interest and tax (EBIT) of $225000. In order to save on taxes. FT's CEO suggests that the firm should issue new debt to the market and use the proceeds of the debt issue to retire a portion of its equity. The capital structure change results in $120000 of new debt with an annual interest expense of 10 percent. Assume no other changes to Flying Tiger. How much in taxes will Flying Tiger save, per year, as a result of the decision to issue debt and retire equity?

Answer 1

Flying Tiger Corp will save $4,200 per year in taxes as a result of issuing $120,000 in debt at a 10% interest rate and using a hypothetical 35% tax rate to calculate the tax shield.

Step-by-step explanation:

To determine how much in taxes Flying Tiger Corp will save per year as a result of the decision to issue debt and retire equity, we need to calculate the tax shield from the new debt. Flying Tiger Corp is issuing $120,000 in new debt with an annual interest expense of 10%. The tax savings is the interest expense times the tax rate.

If we assume a corporate tax rate of, let's say 35%, the tax savings on the interest expense would be:

Tax Savings = Interest Expense × Tax Rate

Tax Savings = $120,000 × 10% × 35%

= $4,200

Therefore, Flying Tiger Corp will save $4,200 in taxes per year following this capital structure change. Please note you will have to know the real tax rate to use for exact calculations since it was assumed here for illustrative purposes.