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Safeco Inc. has no debt, and maintains a policy of holding $10 million in excess cash reserves,...

Question:

Safeco Inc. has no debt, and maintains a policy of holding {eq}\$10 {/eq} million in excess cash reserves, invested in risk-free Treasury securities. If Safeco pays a corporate tax rate of {eq}35 \% {/eq}, what is the cost of permanently maintaining this {eq}\$10 {/eq} million reserve? (What is the present value of the additional taxes that Safeco will pay?)

Debt

Debt is the amount of money borrowed by one party (party can be an individual or a company or an institution) from another party to meet its financial requirements.

Usually, in this kind of financial agreement, the lender lends the money to the borrower with terms and conditions that it must be returned at a later agreed date with an agreed rate of interest.

Answer and Explanation:

Safeco Inc. has no debt and maintains a policy of holding $10million in excess cash reserves, invested in risk-free Treasury securities. If Safeco pays a corporate tax rate of 35%, the cost of permanently maintaining this $10million reserve is:

To find the cost of permanently maintaining $10 million reserves we need to determine the present value of the additional taxes that Safeco will pay.

Holding (D) = - $10 million (this value is the negative debt amount as the company has to maintain $10 million in excess)

Tax rate = 35% = 0.35

So the PV (Interest tax shield) = -$10,000,000 * 0.35 = -$3,500,000 = -$3.5 million

Hence the cost of permanently maintaining the $10 million reserve is = -$3.5 million (which is the present value of the future taxes paid by Safeco).


Learn more about this topic:

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Long-Term Debt: Definition, Cost & Formula

from Financial Accounting: Help and Review

Chapter 8 / Lesson 7
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