Assume a company has earnings before earnings and taxes (EBIT) of $10 million. I

Question

Assume a company has earnings before earnings and taxes (EBIT) of $10 million.

Interest payments on the company%u2019s debt are $2 million, and its corporate tax rate is 35%.

Construct a simple income statement (beginning with EBIT) to show that the interest paid on debt reduces the taxes the firm owes to the government. More specifically, produce two income statements, beginning with EBIT as your starting point, under the conditions where INT = $2 million in one income statement and where INT = $0 in the second income statement.  

Next, how much more would this company pay in taxes (that is, change in T) if it were financed solely by equity (so that wd would be 0 in its capital structure)?

Explanation / Answer

EBIT = $10 mn

interest = 2 mn

tax rate = 35%

EBT = 8 mn

PAT = .65*8 = 5.2 mn

tax paid = 8-5.2 = 2.8 mn

now without interest payment

tax payment = .35*10 = 3.5 mn

PAT = 6.5 mn

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