No debts return on assets before taxes

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Reference no: EM131459494

NoDebt has $500 in assests and $500 in quity. Its return on assets before taxes (EBIT and taxes/total assets) is 20%, and the income tax rate is 40%. SellDebt approched NoDebt with the offer to lend $200 to NoDebt. The interest rate is %25% APR paid annually. Sell Debt tells NoDebt that, sinse the interest is tax-deductible, the after tax interest rate is effectively 25% multiplied by 0.6=15% which is lower than the ROA of 20%. Thus Nodebt effectively 25% multiplied by 0.6=15% which is lower than the ROA of 20%. Assume that if NoDebt borrows $200 from SellDebt it will use the proceeds to reduce equity (by butying back stock or by paying dividents)i.e., that it faxes zero risk. Its tatal assets would remain the same. For simplicity, assume that No debts return on assets before taxes will continue to be 20% forever i.e, that it faces zero risk. Should it borrow at the given rate?

Reference no: EM131459494

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