Tri-States Gas Producers expects to borrow $800,000 for field engineering improvements. Two methods of debt financing are possible—borrow it all from a bank or issue debenture bonds. The com­pany will pay an effective 8% per year to the bank for 8 years. The principal on the loan will be reduced uniformly over the 8 years, with the remainder of each annual payment going toward interest. The bond issue will be for 800 ten-year bonds of $1000 each that require a 6% per year dividend payment.

Question

(a) Which method of financing is cheaper after an effective tax rate of 40% is considered?
(b) Which is the cheaper method using a before-tax analysis? Is it the same as the after-tax choice?

Answer 1

(a) Bank loan
Annual loan payment = 800,000(A/P,8%,8)
= 800,000(0.17401)
= $139,208

Principal payment = 800,000/8 = $100,000
Annual interest = 139,208 – 100,000 = $39,208
Tax saving = 39,208(0.40) = $15,683
Effective interest payment = 39,208 – 15,683 = $23,525
Effective annual payment = 23,525 + 100,000 = $123,525

The AW-based i* relation is:

0 = 800,000(A/P,i*,8) - 123,525
(A/P,i*,8) = 0.15441
i* = 4.95% (RATE function)

Bond issue
Annual bond dividend = 800,000(0.06) = $48,000
Tax saving = 48,000(0.40) = $19,200
Effective bond dividend = 48,000 – 19,200 = $28,800

The AW-based i* relation is:

0 = 800,000(A/P,i*,10) - 28,800 - 800,000(A/F,i*,10)

i* = 3.60% (RATE or IRR function)

Bond financing is cheaper.

(b) Before taxes: bonds cost 6% per year, which is less than the 8% loan. The answer before taxes is the same as that after taxes.