Presently, H. Swank, Inc., does not use any finan- cial leverage and has total financing equal to $1 million. It is considering refinancing and issuing $500,000 of debt that pays 5 percent interest and using that money to buy back half the firms common stock. Assume that the debt has a 30-year maturity and that Swank will have no principal payments for 30 years. Swank currently pays all of its net income to common shareholders in the form of cash dividends and intends to continue to do this in the future. The corporate tax rate on the firms earnings is 35 percent. Swanks current income statement (before the debt issue) is as follows:

a. If Swank issues the debt and uses it to buy back common stock, how much money can the firm distribute to its stockholders and bondholders next year if the firms EBIT remains equal to $100,000?

b. What are Swanks interest tax savings from the issuance of the debt?

c. Are Swanks stockholders better off after the debt issue? Why or why not?

Net operating income (EBIT) Interest expense Earnings before taxes Income taxes Net income $100,000 0 $100,000 (35,000) $ 65,000