Question

Corporation A decides to borrow $1,000,000 and use the money to buy back $1,000,000 of its common stock. The corporation pays 6% interest on its borrowed funds which exactly equals the amount of the dividend it used to pay on the common stock it repurchased. Therefore, Selected answer will be automatically saved. For keyboard navigation, press up/down arrow keys to select an answer. a Corporation A's operating income will decrease due to higher interest expense. b Corporation A's retained earnings will increase due to the tax deductibility of interest expense. c Corporation A will have no change in its operating income since the interest expense exactly offsets the prior dividend payment. d Corporation A's gross profit will decrease.

Answer 1

Corporation A's transaction to borrow funds for stock repurchase and replace dividends with interest payments will increase the retained earnings due to the tax deductibility of interest. Operating income and gross profit remain unaffected by this transaction because interest is a non-operating expense.

Step-by-step explanation:

The scenario presented involves Corporation A engaging in a financial strategy where it borrows money to repurchase its own common stock. The key point to note here is that while dividends do not lead to a tax benefit, interest payments on debt are generally tax-deductible. This difference affects the company's retained earnings and operating income.

When corporation A replaces dividends with interest payments, the interest paid on the borrowed funds is indeed a tax-deductible expense, which affects the net income and subsequently the retained earnings. Therefore, the selection b) "Corporation A's retained earnings will increase due to the tax deductibility of interest expense" is correct because the tax savings from interest expense deduction will increase the retained earnings, assuming other factors remain constant.

Choices a), c) and d) mention effects on operating income and gross profit, which are not directly affected by this stock buyback and debt transaction. Interest is considered a non-operating expense, thus it does not affect the operating income. Furthermore, gross profit is calculated before operating expenses and is not affected by financial activities such as interest payments.