PDQ, Inc., expects EBIT to be approximately $11.8 million per year for the foreseeable future, and it has 100,000, 20-year, 7 percent annual coupon bonds outstanding.
What would the appropriate tax rate be for use in the calculation of the debt component of PDQ's WACC? (Round your answer to 2 decimal places.)
Taxable income is the base upon which tax is imposed by any income tax authority. Normally, it includes all items of income and is reduced by expenses and other applicable deductions. The amounts included as income, expenses, and other deductions vary from country to country, and so do the tax rates.
Answer and Explanation:
The appropriate tax rate for use in the calculation of the debt component of WACC is the marginal tax rate for the firm. The marginal tax rate depends on the time period this question refers. Prior to the 2018 tax reform, corporate tax is progressive. After the tax reform, the progressive corporate tax has been replaced by a flat tax rate.
Suppose the relevant time frame is before 2018, then we first have to compute the taxable income, which is EBIT net of interest payment. The interest payments on the bonds would be 100,000 x $1,000(FV) x 0.07 = $7 million, resulting in EBT of $11.8 million - $7 million = $4.8 million.
As taxable income falls from a 35 percent tax bracket to a 34 percent tax bracket. Thus the marginal tax rate is 35%.
If the relevant time frame is after 2018, the 2018 tax reforms imposed a universal 21% tax rate on corporate income. In this case, the appropriate tax rate is 21%.
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from Accounting 202: Intermediate Accounting IIChapter 8 / Lesson 2