3.5 Taxes owed by Firm A fall from $21 million to $14 million. The reduction in taxes is 35% of the extra $20 million of interest income. Net income does not fall by the full $20 million of extra interest expense. It instead falls by interest expense less the reduction in taxes, or $20 million - $7 million = $13 million.

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Firm A Firm B EBIT 100 100 Interest 60 0 Pretax income 40 100 Tax (35% of pretax income) 14 35 Net income 26 65