15–8. (Computing interest tax savings) Presently, H. Swank, Inc., does not use any finan- cial leverage and has total financing equal to $1 million. It is considering refinancing and issuing $500,000 of debt that pays 5 percent interest and using that money to buy back half the firm's common stock. Assume that the debt has a 30-year maturity and that Swank will have no principal payments for 30 years. Swank currently pays all of its net income to common shareholders in the form of cash dividends and intends to continue to do this in the future. The corporate tax rate on the firm's earnings is 35 percent. Swank's current income statement (before the debt issue) is as follows: $100,000 Net operating income (EBIT) Interest expense Earnings before taxes $100,000 (35,000) $ 65,000 Income taxes Net income a. If Swank issues the debt and uses it to buy back common stock, how much money can the firm distribute to its stockholders and bondholders next year if the firm's EBIT remains equal to $100,000? b. What are Swank's interest tax savings from the issuance of the debt? c. Are Swank's stockholders better off after the debt issue? Why or why not?
15–8. (Computing interest tax savings) Presently, H. Swank, Inc., does not use any finan- cial leverage and has total financing equal to $1 million. It is considering refinancing and issuing $500,000 of debt that pays 5 percent interest and using that money to buy back half the firm's common stock. Assume that the debt has a 30-year maturity and that Swank will have no principal payments for 30 years. Swank currently pays all of its net income to common shareholders in the form of cash dividends and intends to continue to do this in the future. The corporate tax rate on the firm's earnings is 35 percent. Swank's current income statement (before the debt issue) is as follows: $100,000 Net operating income (EBIT) Interest expense Earnings before taxes $100,000 (35,000) $ 65,000 Income taxes Net income a. If Swank issues the debt and uses it to buy back common stock, how much money can the firm distribute to its stockholders and bondholders next year if the firm's EBIT remains equal to $100,000? b. What are Swank's interest tax savings from the issuance of the debt? c. Are Swank's stockholders better off after the debt issue? Why or why not?
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Transcribed Image Text:15-8. (Computing interest tax savings) Presently, H. Swank, Inc., does not use any finan-
cial leverage and has total financing equal to $1 million. It is considering refinancing
and issuing $500,000 of debt that pays 5 percent interest and using that money to buy
back half the firm's common stock. Assume that the debt has a 30-year maturity and
that Swank will have no principal payments for 30 years. Swank currently pays all of
its net income to common shareholders in the form of cash dividends and intends to
continue to do this in the future. The corporate tax rate on the firm's earnings is 35
percent. Swank's current income statement (before the debt issue) is as follows:
$100,000
Net operating income (EBIT)
Interest expense
Earnings before taxes
Income taxes
$100,000
(35,000)
$ 65,000
Net income
a. If Swank issues the debt and uses it to buy back common stock, how much money
can the firm distribute to its stockholders and bondholders next year if the firm's
EBIT remains equal to $100,000?
b. What are Swank's interest tax savings from the issuance of the debt?
c. Are Swank's stockholders better off after the debt issue? Why or why not?
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