Consider two firms, Go Debt Corporation and No Debt Corporation. Both firms are
ID: 2678104 • Letter: C
Question
Consider two firms, Go Debt Corporation and No Debt Corporation. Both firms are expected to have earnings before interest and taxes of $100,000 during the coming year. In addition, Go Debt is expected to incur $40,000 in interest expenses as a result of its borrowings whereas No Debt will incur no interest expense because it does not use debt financing. However, No Debt will have to pay stockholders $40,000 in dividend income. Both firms are in the 40 percent tax bracket. Calculate the Earnings after tax for both firms. Which firm has the higher after-tax earnings? Which firm appears to have the higher cash flow? How do you account for the difference?Explanation / Answer
Go Debt EBIT = $100,000 Net income =( $100,000 -$40,000 )*60% =$36,000 No Debt EBIT =$100,000 Net income =( $100,000 )*60% = $60,000 No debt has higher after-tax earnings because there is no interest expense.