Question

Simons Industries has just borrowed $1 million by issuing 20-year bonds. The company’s cost of debt is 5% so it will need to pay $50,000 in interest each year for the next 20 years and then repay the principal of $1 million in year 20. The company’s marginal tax rate is 30%. How much should the interest tax shield increase the value of Simons?

Answer 1

Bond amount= 1000000

Interest amount= 50000

Interest rate or Discount rate (i)= 5%

Tax rate = 30%

Time (n) = 20 years

Formula for interest tax shield = Interest * tax rate

50000*30%

$15000

Each year up to 20 years is same amount of Interest tax shield due to loan repayment in 20th year. so to Calculate present value, p.v. of annuity formula become applicable

P.V. of tax shield = Interest tax shield*(1-(1/(1+i)^n))/i

15000*(1-(1/(1+5%)^20))/5%

186933.1551

So, Interest tax shield will add $186,933.16 to the Value of Simons