Effects On Incentives To Borrow

Transcript for Effects on Incentives to Borrow

Link to the spreadsheet used in the above video

In Business, Interest Reduces Taxable Income

The Business Case for Finance Rather than Cash

Classroom Quiz Example:

You're a business and want to purchase a car. Car cost: $ $20,000, MARR: 10%, Combined tax rate: 30%

Choices: buy w/ cash or finance with a loan (single payment next year, interest: 12%)

  • Choice 1: Cash
Year Pre-Tax
0 -20,000
1 0

PW=-20,000

  • Choice 2: Loan
Year Pre-Tax Interest Expense Tax Savings After Tax
0 0 0 0 0
1 -22,400 2400 (2400*.3)=720 -21,680

PW=(-21,680)/1.1 = -19,709

-19,709 > -20,000 so——> finance car

Another example of Effects On Incentives To Borrow

●Overall goal: Purchase a house
●Total cost to buyer: 100,000
●MARR: 10%
●Interest rate on loan (unchanging): 15%
●Combined tax rate: 50%

Purchase options:
1. Cash

Year Pre-tax
0 -100,000
1 0

2. Bank Loan

Year Pre-tax Interest expense Tax Savings After Tax
0 0 0 0 0
1 -115,000 15,000 15,000*.50=7,500 -107,500
2 -95,000 15,000 15,000*.50=7,500 -87,500
3 -67,500 15,000 15,000*.50=7,500 -60,000

* Annual payment of 20,000; therefore, for any given year: Pre-taxed amount + 20,000

●2nd year PW: -107,500/1.1= -97,727.27
●3rd year PW: -87,500/1.3310 = -65,740.05
●4th year PW: -60,000/1.4641= -40,980.80

-> Rationale for financing vs. paying cash: Every year the PW is consistently lower than the initial cost (-100,000).

-> The tax savings after only 2 years yields a higher profit than the desired MARR. While it appears that by way of this formula the buyer pays more per year when the interest expense is applied, the tax savings elicits higher benefits throughout the course of several years. With the tax savings brought on by paying interest, a single cash payment seems less desirable than utilizing a loan-based payment plan.

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