Question

12. Corporate Debt. Haricot Corp. and Pinto Corp. both have profits of $100 million. Haricot is financed solely by equity, while Pinto has issued $150 million of 8% debt. If the corporate tax rate is 35%:
(a) How much tax does each company pay?
(b) What is the total payout to investors (debtholders plus shareholders) of each company?

Answer 1

Answer:

(a) $35 million; $30.8 million

(b) (i) $0; $65 million

    (ii) $12 million; $57.2 million

Explanation:

(a) Tax on Haricot Corp. = corporate tax rate ×  profits

                                        = 35% × $100 million

                                        = $35 million

Interest on dept of Pinto = Issued by Pinto × Rate of debt

                                         = $150 million × 8%

                                         = $12 million

Pinto's profit after interest = Profits - Interest

                                           = $100 million - $12 million

                                           = $88 million

Therefore,

Tax on Pinto Corp. = corporate tax rate ×  profits after interest

                               = 35% × $88 million

                               = $30.8 million

(b)

Haricot Corp.:

Return to Debtholders = $0

Return to shareholders = Profits - Tax amount

                                       = $100 million - $35 million

                                       = $65 million

Pinto Corp.:

Return to Debtholders = $12 million

Return to shareholders = Profits - Tax amount - Interest

                                       = $100 million - $30.8 million - $12 million

                                       = $57.2 million