Suppose the corporate tax rate is 35%, and investors pay a tax rate of 30% on income from dividends or capital gains and a tax rate of 33.1% on interest income. Your firm decides to add debt so it will pay an additional $10 million in interest each year. It will pay this interest expense by cutting its dividend.

a. How much will debt holders receive after paying taxes on the interest they earn?

b. By how much will the firm need to cut its dividend each year to pay this interest expense?

c. By how much will this cut in the dividend reduce equity holders’ annual after-tax income?

d. How much less will the government receive in total tax revenues each year?

e. What is the effective tax advantage of debt t*?

AppendixLO1