Company A and Company B are identical in all regards except that during Year 1 Company A borrowed $40,000 at an interest rate of 10%.In contrast,Company B obtained financing by acquiring $40,000 from sale of common stock.Company B agreed to pay a $4,000 cash dividend each year.Both companies are in a 30% tax bracket.Which company would show the greater retained earnings at the end of Year 1,and by what amount?
A)Company A's retained earnings would be higher by $4,000.
B)Company B's retained earnings would be higher by $2,800.
C)Company A's retained earnings would be higher by $1,200.
D)Both would show the same retained earnings.

Question

Quizplus · Accepted Answer

Company A:
Interest expense = Face value of bonds of $40,000 × 10% = $4,000
After-tax cost of debt = Total interest expense of $4,000 × (1.0 - 0.30)= $2,800
Tax savings = $4,000 - $2,800 = $1,200
The $4,000 cash dividend has no tax savings.Therefore,Company A's net income for Year 1 and its retained earnings at the end of Year 1 would be $1,200 higher than Company B's.

Company a and Company B Are Identical in All Regards