Exhibit 3-2 Equity versus Debt Financing (in thousands) Income Statement $100 40 G0 30 $100 40 60 30 20 10 Cost of goods sold Gross profit Operating expenses interest Pretax income 30 Income tax expense (40%) 12 Net department income S6 Note that Department B's net income is only $12,000 less than that of Department A (S6,000 versus $18,000), despite its interest expense of $20,000. That financing charge effectively shields $20,000 of Department B's revenues from taxation, allowing taxing authorities to claim only 40% of $10.000 and not 40% of $30,000. Consequently, interest expense shields a portion of revenues from taxation and reduces the firm's effective cost of borrowing. One computes the effective cost of debt as interest multiplied by one minus the income tax rate. The cost of debt financing for the firm (or specifically Department B in this case) is therefore 6% ($12,000 / $200,000), and not 10% ($20,000 / $200,000). expense