CP

The Federal Income Tax System 363

its after-tax income would be $6,265. Other factors might lead GE to invest in bonds,

but the tax factor certainly favors stock investments when the investor is a corporation.^16

Interest and Dividends Paid by a Corporation A firm’s operations can be fi-

nanced with either debt or equity capital. If it uses debt, it must pay interest on this

debt, whereas if it uses equity, it is expected to pay dividends to the equity investors

(stockholders). The interest paidby a corporation is deducted from its operating in-

come to obtain its taxable income, but dividends paid are not deductible. Therefore, a

firm needs $1 of pre-tax income to pay $1 of interest, but if it is in the 40 percent

federal-plus-state tax bracket, it must earn $1.67 of pre-tax income to pay $1 of dividends:

.

Working backward, if a company has $1.67 in pre-tax income, it must pay $0.67 in

taxes [(0.4)($1.67) $0.67]. This leaves it with after-tax income of $1.00.

Table 9-8 shows the situation for a firm with $10 million of assets, sales of $5 mil-

lion, and $1.5 million of earnings before interest and taxes (EBIT). As shown in Col-

umn 1, if the firm were financed entirely by bonds, and if it made interest payments of

$1.5 million, its taxable income would be zero, taxes would be zero, and its investors

would receive the entire $1.5 million. (The term investorsincludes both stockholders

and bondholders.) However, as shown in Column 2, if the firm had no debt and was

therefore financed only by stock, all of the $1.5 million of EBIT would be taxable

income to the corporation, the tax would be $1,500,000(0.40) $600,000, and in-

vestors would receive only $0.9 million versus $1.5 million under debt financing. The

rate of return to investors on their $10 million investment is therefore much higher if

debt is used.

Pre-tax income needed

to pay $1 of dividends



$1

1 
Tax rate



$1

0.60

$1.67

(^16) This illustration demonstrates why corporations favor investing in lower-yielding preferred stocks over
higher-yielding bonds. When tax consequences are considered, the yield on the preferred stock, 1

0.35(0.30) 6.265%, is higher than the yield on the bond, (1
0.35)(8.0%) 5.200%. Also, note
that corporations are restricted in their use of borrowed funds to purchase other firms’ preferred or com-
mon stocks. Without such restrictions, firms could engage in tax arbitrage,whereby the interest on bor-
rowed funds reduces taxable income on a dollar-for-dollar basis, but taxable income is increased by only
$0.30 per dollar of dividend income. Thus, current tax laws reduce the 70 percent dividend exclusion in
proportion to the amount of borrowed funds used to purchase the stock.
TABLE 9-8 Returns to Investors under Bond and Stock Financing
Use Bonds Use Stock
(1) (2)
Sales $ 5,000,000 $ 5,000,000
Operating costs 3,500,000 3,500,000
Earnings before interest and taxes (EBIT) $1,500,000 $1,500,000
Interest 1,500,000 0
Taxable income $ 0 $1,500,000
Federal-plus-state taxes (40%) 0 600,000
After-tax income $ 0 $ 900,000
Income to investors $1,500,000 $ 900,000
Rate of return on $10 million of assets 15.0% 9.0%
See Ch 09 Tool Kit.xls
for details.

Financial Statements, Cash Flow, and Taxes 359