Chapter 15, Problem 1P

a)

Summary Introduction

To determine: The net income for 2006.

Introduction:

The net income is a company’s total profit; it is calculated by talking revenues and deducting the cost of doing business like taxes, depreciation interest and other expenses. Net income measures the profitability of the company over a period of time.

Answer to Problem 1P

The net income for 2006 is $120 million.

Explanation of Solution

Given information:

P Pharmaceuticals has EBIT of $325 million in 2006; it has interest expenses of $125million and tax of 40%.

Formula to compute net income:

$\text{Net income}=(\text{EBIT}-\text{Interest)}\times (1-\text{Taxes})$

Where,

EBIT (Earnings Before Interest and Taxes).

Compute the net income:

$\begin{array}{c}\text{Net income}=(\text{EBIT}-\text{Interest)}\times (1-\text{Taxes})\\ =(\$325-\$125)\times (1-40\%)\\ =200\times (1-0.4)\\ =200\times (0.6)\end{array}$

$=\$120$

Hence, the net income for 2006 is $120 million.

b)

Summary Introduction

To determine: The net income for 2006.

Introduction:

The net income is a company’s total profit; it is calculated by talking revenues and deducting the cost of doing business like taxes, depreciation interest and other expenses. Net income measures the profitability of the company over a period of time.

Answer to Problem 1P

The total net income for 2006 is $245 million.

Explanation of Solution

Given information:

P Pharmaceuticals has EBIT of $325 million in 2006;it has interest expenses of $125 million and tax of 40%.

Formula to compute total net income:

$\text{Total net income}=\text{Net income}+\text{Interest}$

Compute the total net income:

$\begin{array}{c}\text{Total net income}=\text{Net income}+\text{Interest}\\ =\$120+\$125\\ =\$245\end{array}$

Hence, the total net income for 2006 is $245 million.

c)

Summary Introduction

To determine: The net income when there is no interest expenses in 2006 and to compare with the total net income.

Introduction:

The net income is a company’s total profit; it is calculated by talking revenues and deducting the cost of doing business like taxes, depreciation interest and other expenses. Net income measures the profitability of the company over a period of time.

Answer to Problem 1P

The total net income for 2006 is $245 million.

Explanation of Solution

Given information:

P Pharmaceuticals has EBIT of $325 million in 2006, and corporate tax of 40%.

Formula to compute net income without interest expenses:

$\text{Net income}=\text{EBIT}\times (1-\text{Taxes})$

Compute the total net income without interest expenses:

$\begin{array}{c}\text{Net income}=\text{EBIT}\times (1-\text{Taxes})\\ =\$325\times (1-40\%)\\ =\$325\times (1-0.4)\\ =\$325\times (0.6)\end{array}$

$=\$125$

Hence, the net income without interest expense for the year 2006 is $195 million.

Formula to compare total net income without interest expenses:

$\text{Total net income}-\text{Net income without expenses}$

Compute the total net income without interest expenses:

$\begin{array}{c}\text{Total net income without interest expenses =}\left(\begin{array}{l}\text{Total net income}-\\ \text{Net income without expenses}\end{array}\right)\\ =\$245-\$195\\ =\$50\end{array}$

Hence, the total net income is higher with $50million than the net income without expenses.

d)

Summary Introduction

To determine: The interest tax shield in 2006.

Introduction:

An interest tax shield is a deduction in taxable income for a corporation or an individual achieved through claiming deduction like depreciation, charitable donations and, mortgage interest. Tax shield lowers the overall cost of taxes owned by the individual taxpayer.

Answer to Problem 1P

The interest tax shield for 2006 is $50 million.

Explanation of Solution

Given information:

P Pharmaceuticals has EBIT of $325 million in 2006, has interest expenses of $125million and tax of 40%.

Formula to compute interest tax shield:

$\text{Interest tax shield}=\text{Corporate tax rate}\times \text{Interest payments}$

Compute the interest tax shield:

$\begin{array}{c}\text{Interest tax shield}=\text{Corporate tax rate}\times \text{Interest payments}\\ =\$125\times 40\%\\ =\$125\times 0.4\\ =\$50\end{array}$

Hence, the interest tax shield for the year 2006 is $50 million.