Example of Debt Finance
An example:
Interest = 10% tax rate = 30%
The effective cost of debt (interest) = Interest rate (1 - T)
= 10%(1-0.30)
= 7%
Consider companies A and B
Company A B
Sh.'000' Sh.'000'
10% debt 1,000 -
Equity - 1,000
1,000 1,000
The tax rate is 30% and earnings previous interest and tax amount to Ksh.400,000. All earnings are paid out as dividends. Calculate payable via each firm.
EBIT 400 400
Less interest 10% x 1,000 (100) -
EBT 300 400
Less tax @ 30% (90) (120)
Dividends payable 210 280
Company A saves tax equal to Sh.30,000(120,000 - 90,000) since interest charges are tax permit able and reduce taxable income.